Tools and Techniques Used in Financial Analysis

Financial analysis is useful in the assessment of a company’s financial performance over time and identification of the trends in that performance. It can also be used in the valuation of a company’s equity securities, assessment of its financial risk exposures, and performance of necessary due diligence ahead of a prospective merger or acquisition.

There are several tools and techniques which may be used when evaluating a company’s financial status. These tools and techniques can especially be useful when reviewing a company’s financial data over time (time-series analysis) vis-a-vis the performance of other companies (cross-sectional analysis). These tools and techniques include financial ratios, common-sizing financial statements, currency translations, and chart analysis.

Uses and Limitations of the Tools and Techniques Used in Financial Analysis

Ratio Analysis

Ratio analysis enables the evaluation of a company’s past performances and assessment of its current financial position. Besides, it provides insights that can be used to project a company’s future results.

Limitations to ratio analysis include:

• comparing companies is difficult sometimes due to the heterogeneity or homogeneity of their operating activities;
• sometimes the use of several ratios in ratio analysis may lead to inconsistent results;
• judgment must be used sometimes; and
• the use of different accounting methods by companies necessitates adjustments of financial data before meaningful comparisons can be made.

Common-size Analysis

The common-size analysis involves the creation of a ratio between each financial statement item and a base item. This, typically, translates to total assets (when common-sizing the balance sheet) or total revenue (when common-sizing the income statement).

The vertical common-size analysis highlights the composition of the balance sheet and helps to answer questions such as what mix of assets the company is using, how it is financing itself, and how its balance sheet composition compares with that of its peers. Finally, the vertical common-size analysis offers reasons behind the differences that may exist among companies in the same industry and environment.

Horizontal common-size analysis can highlight structural changes that have occurred in a company over time. An analysis of past trends (historical analysis) can help to develop future expectations by evaluating whether trends are likely to remain constant or change.

Trend analysis provides useful information on a company’s historical performance and growth. It can be used as a planning and forecasting tool for management and analysts.

Cross-sectional analysis or relative analysis compares metrics for one company with the same metrics for another company. This allows comparisons to be made irrespective of whether or not the companies are of significantly different sizes and/or report financial data in different currencies.

Whenever companies whose financial performance is being compared differ significantly in regard to size and/or the currency in which their financial data is reported, a comparison of their net income as reported will not be useful. Financial ratios and common-size financial statements can remove size as a factor and enable a more feasible comparison. Additionally, in addressing the challenge of data being reported in different currencies:

• all reported amounts may be translated into one common currency using the foreign exchange rates at the end of a period; or
• all reported amounts may be translated into one common currency using the average foreign exchange rates during the period; or
• comparability is possible without the translation of currencies if ratio analysis is the primary focus.

The reported nominal currency revenue or net income amounts for a company may not highlight significant changes in its performance over time. However, using ratio analysis, charts, or stating financial statement quantities relative to a selected base year value, can make these changes more visible and apparent.

Differences in fiscal year ends can pose a challenge to comparability. This can be overcome by using the trailing twelve months of data.

Differences in accounting standards can also limit comparability. A financial analyst should, however, seek to identify where these differences lie and the impact they may have on comparability. As best as possible, this impact should be minimized by making adjustments where feasible.

Graphs

Graphs can be used to facilitate a comparison of the performance and financial structure of a company over time. They can highlight the necessary changes in significant aspects of a company’s operations. Moreover, graphs can provide a visual overview of trends in risks.

Regression Analysis

Regression analysis helps to identify relationships between variables which can lead to forecast estimates. It can also facilitate the identification of items or ratios that are moving contrary to their historical statistical relationships.

Question 1

Which of the following is least likely a typical approach to comparing financial data that is reported in different currencies?

1. Comparing financial data using ratios.
2. Using trailing twelve months of data for each company being compared.
3. Translating all reported currencies into one common currency using the foreign exchange rates prevailing at the end of the relevant period.

Solution

The correct answer is B.

Using trailing twelve months of data is useful when differences exist in the fiscal year ends of the companies being compared. It is not used for comparing companies whose differences lie in the reporting currency used to prepare their financial statements.

Options A and C describe typical approaches to overcome differences in reported currencies.

Question 2

To compare the performance of two companies with different end-of-period dates, an analyst would most likely use:

1. Ratio analysis.
2. Regression analysis.
3. Trailing twelve months analysis.

Solution

The correct answer is C.

It is better to start the comparison by compounding the financial results of each company. The rationale for doing so is to match the data collected on each company with the data collected on the other company (in terms of time of occurrence). In other words, an analyst must compound the financial data of the trailing twelve months of each company first to make sure that he is comparing apples to apples.