Financial Analysis Techniques: Analytical Process, Tools & Techniques | CFA Level I FSA
Welcome back to our new topic on financial analysis techniques. This is an important topic because one of the key capabilities of an analyst is the ability to compute ratios and make inferences from these ratios.
In this first part, we will revise the financial statement analysis framework and introduce four tools and techniques that are commonly used in financial statement analysis. Let’s dive right in.
Financial Statement Analysis Framework
The financial statement analysis framework consists of six formal steps:
- State the objective and context: Determine the questions to be answered, the presentation format, and the resources and time available for the analysis.
- Gather the data: Acquire the company’s financial statements and other relevant data on its industry and the economy.
- Process the data: Make appropriate adjustments to the financial statements, calculate ratios, and prepare exhibits such as graphs and common-size balance sheets.
- Analyze and interpret the data: Use the data to answer the questions stated in the first step and decide what conclusions or recommendations the information supports.
- Report the conclusions or recommendations: Prepare a report and communicate it to the intended audience.
- Update the analysis: Repeat these steps and update the conclusions and recommendations periodically.
The primary focus of this topic is on Phases 3 and 4, processing and analyzing data. We will start by looking at the various tools and techniques commonly used to process the data into formats that facilitate analysis. These include common-size analysis, graphical analysis, regression analysis, and ratio analysis.
Common-size statements normalize balance sheets and income statements, allowing comparison of performance across firms and for a single firm over time. There are two categories of common-size statements: vertical common-size statements and horizontal common-size statements.
- Vertical common-size statements: All values in each vertical column are expressed as a percentage of the revenue in that column. These statements can be used to compare the income statement across two firms or across time periods for a single firm.
- Horizontal common-size statements: All values in each row are expressed as a ratio against the first item, which is the first-year value. Trends in the value of these items over time are readily apparent from the horizontal statements.
Graphs provide the analyst with a visual overview of risk trends in a business and can also be used to communicate the analyst’s conclusions regarding the data.
- Pie graphs: More appropriate for communicating the composition of a total value. Limited to visualizing just a snapshot of the data at a particular time.
- Line graphs: Useful for observing the change in values of individual items over a period of time. Difficult to visualize the composition and the trend in total value from this graph.
- Stacked column graphs: Useful for observing the composition, total amounts, and their change over time. Immediately apparent trends can be identified.
For more complex situations, regression analysis can help identify relationships between variables. For example, a regression analysis could relate a company’s sales to GDP over time, providing insight into whether the company is cyclical. In addition, the statistical relationship between sales and GDP could be used as a basis for forecasting sales.
Similar to the tools mentioned previously, ratios are also useful tools for expressing relationships among data. They can be used for internal comparisons and comparisons across firms. However, analysts must be aware of some limitations when dealing with ratios:
- Financial ratios are not useful when viewed in isolation. They are only informative when compared to those of other firms or to the company’s historical performance.
- Comparisons with other companies are made more difficult by different accounting treatments.
- Companies may have divisions operating in many different industries, making it difficult to find comparable industry ratios for comparison purposes.
- Analysts should view all ratios relative to one another and be aware that conclusions cannot be made by calculating a single ratio.
- Determining the target or comparison value for a ratio is difficult. Most analysts give a range of acceptable values, rather than a point value.
- Definitions of ratios can vary widely among the analytical community. Consistency is paramount when dealing with ratios.
Context is important when interpreting financial ratios. In general, the financial ratios of a company are compared with those of its major competitors and to the company’s prior periods. The goal is to understand the underlying causes of divergence between a company’s ratios and those of the industry. Even ratios that remain consistent can sometimes indicate accounts manipulation!
An analyst should evaluate financial ratios based on the company’s goals and strategy. The actual ratios achieved by the company can be compared with the stated company objectives to determine whether the objectives have been met and whether the results are consistent with the strategy.
Ratios can also be evaluated based on industry norms. A company can be compared with others in its industry by relating its financial ratios to industry norms or to a subset of the companies in an industry. However, care must be taken when using industry norms for comparison, as many ratios are industry-specific, companies may have different lines of business, and differences in accounting methods can distort financial ratios.
Another factor to consider is the economic conditions. For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions. Therefore, financial ratios should be examined in light of the current phase of the business cycle.
And that concludes this first part on financial analysis techniques, where we touched on the various tools and techniques used in the analytical process. In our next lesson, we will discuss more about ratios. See you later!