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Role of financial analysts whether working as an employee or an independent analyst is to provide recommendations and suggestions to their clients regarding economic decisions in particular situation.
The scope and extent of analysts’ work vary from one situation to another and to help cater needs of the user and also to help analysts conduct analysis efficiently and effectively financial analysts around the world follow a generic financial statement analysis framework that is adapted from the “Stages of the analytical review process” as suggested under the book Analysis and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, Second edition by Hennie Van Greuning and Sonja Brajovic Bratanovic
According to this framework there are SIX (6) stages or phases or steps which should be followed to conduct financial statement analysis. All six steps are connected to each other in a series where the outcome of one phase will serve as an input to the next. Each phase has its own crucial importance requiring different tasks to be done in order to initiate next phase properly.
Following are the SIX steps, phases or stages in financial statement analysis framework:
First and foremost one must know the purpose of analysis before any analysis work starts. It is of great importance as it helps in setting the direction of analysis which is otherwise waste of time and most probably end up providing no help at all to the end user.
Knowing the purpose of analysis, analysts define how to approach next phases of analysis that are also highlighted in the framework above. In some cases the analytical task is obvious as it is either carried out on repetitive basis or require less judgmental decisions on part of analyst. In such cases source of information and the analytical techniques to be applied are already known and in place and thus involves small amount of client-analyst discussions.
However, most of the time the analyst has to sit down with the client to understand what are the requirements of analysis and what is needed in the end. Understanding this part let the analyst decide about the techniques, information needs, the way the results to be interpreted and the manner of communication of end result.
On the outlook it seems that analysis is about calculating few ratios and commenting on the results by comparing few figures but reality is quite opposite and this is what separate an ordinary analyst from a professional analyst. Professional analysts first determine the direction and avoid pointless calculations and discussions that instead of helping the end user may cause confusion as a result of irrelevant information and information overload. One must not forget that the reason for having an analysis is to help user decide and not to make the user aware about every possible piece of information.
It is this stage when analyst also decide regarding intended audience, their needs and their stakes so that he can come up with relevant conclusions and recommendations. Another important factor is time as the amount of time available to analyst to prepare the analysis also affect the process and its outcome.
Once the purpose is clear analyst will proceed with extracting relevant information to start the analytical process. The data analyst collect is not limited to financial data alone. In case of first engagement with specific client analyst initially understand how entity performs its operations, nature of its business and products, sources of finance and nature of capital at the disposal of management, what kind of legislation are applicable and also includes understanding industrial trends and financial position and performance of competitors in the same industry. To understand all this and much more analyst needs information.
Emphasizing again collecting data is not just collecting the information of the entity and its operations and segments but also include understand the environment surrounding the entity as it directly affects the entity at different levels. As entity has to interact with the environment for both inputs and outputs let it be finance or inventory, entity cannot be studied in isolation and needs to be assessed in context of environmental variables. Especially when forecasts and projections are done the ability of entity is measured in conjunction with environment. For example 1 million capital will perform differently if it is invested in rural areas and the same if invested metropolitan as the risks and rewards are different in both environments.
Major chunk of information for analysis is derived from entity’s financial statements interim and/or final and according to the demands of analysis more information is requested that falls outside of accounting process for example contracts, ownership deeds, leasing agreements etc.
Once the necessary data is collected, analyst process it by applying different techniques that are a mix of quantitative and qualitative techniques. Processing may involve simple comparisons to calculating ratios and may amount to complex statistical analysis involving probability estimations and model simulations.
Following are some of the common tasks that are undertaken at this stage:
The most critical and probably the biggest reason why analysts are required is to interpret the data/information. Information on its own won’t do wonders if it is not understood and interpreted on timely basis as without it no reasonable actions can be taken.
It is the job of analyst to make meaning out of simple numbers and ratios and equations. The whole exercise of doing analysis is useless if it is not followed by any action as it was too difficult to interpret the results. Therefore correct and timely interpretation is at heart of this process.
If investor requires recommendations whether to invest or not the providing ratios and numbers won’t do any good. Rather he needs precise explanations in the light of numbers and quantities measured.
Once the interpretations are finalized they are communicated to the intended user. The format, timing, extent, presentation and classification of elements all depends on numerous factors involving:
As analysis depends on the activities of entity and its environment that are changing constantly therefore analysis itself needs to be dynamic as well. The job of analyst is not finished on submitting report to the users. If the prospects and situation has changed since the date of report then analyst has to check if recommendations are still valid in the new context. Failure to do so will render the whole exercise useless so analyst is required to stay vigilant paying close attention to important factors that may change the view of analysis and given recommendations.