Financial Reporting and Financial Stat ...
Financial reporting and financial statement analysis are two very important terminologies in finance.... Read More
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.
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:
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).
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:
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 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 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?
- Comparing financial data using ratios.
- Using trailing twelve months of data for each company being compared.
- 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:
- Ratio analysis.
- Regression analysis.
- 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.