Basics of financial analysis

Last updated: 09.11.2016

This series includes an introduction to financial analysis. It describes who usually performs the analysis, its objectives, source data, drawbacks and limits or useful benchmarks. Furthermore, it states what the basic methods are and classifies the indicators into groups.

The group of indicators are presented in a separate series called Group of financial analysis indicators (and indicators by clicking on them).

 

 



Who prepares financial analysis

Financial analysis is usually performed:

  • internally – by the employee of the entity (financial analyst, financial manager, controller, financial analyst, accountant etc.).
  • externally:
    • banks or other financial institutions – their evaluation usually results in decision whether to provide a loan, how much, at what interest rate and the amount of guarantee / collateral required
    • suppliers paid on credit
    • the entities providing grants
    • the potential investors
    • exceptionally other interest groups, e.g. customers

 

Every stakeholder performs financial analysis for different purposes and puts thus an emphasis on different indicators. Internally, the company is usually interested in all areas of financial analysis, while banks and suppliers focus their attention more on the ability to pay (i.e. indicators of liquidity and indebtedness) and potential investors on profitability or indicators of market value.

 

In any case, the financial analysis should be carried out by a professional with a good understanding the economy of the analyzed entity. Nowadays, there are several Internet tools for automated processing. Although they are usually already well done and can sometimes even generate a nice report including a verbal assessment, but it is important to remember that:

  • the output of financial analysis will only be as good as its inputs (and it is not always just about mechanical linking of accounts into formulas – please see the article Problems with financial analysis)
  • calculated value in itself will not reveal much - it is necessary to compare it with different bases (all comparatives are not suitable for every indicator, in practice it is very difficult to obtain comparative data and recommended values ​​tend to be very general, however, if there are any), assess the interrelationship of indicators, identify and explain the reasons etc.


Objects of financial analysis and periods covered

Financial analysis can be processed for:

  • individual divisions or segments of the company
  • individual companies
  • group of companies (i.e. on the consolidated level).

 

Financial analysis can be carried out on:

  • historical data
  • future (estimated) data - e.g. financial plans, which, among other things, help evaluate what certain decisions make with the financial results, e.g. investment or implementation of a project.

Purpose and objectives of financial analysis

The purpose of financial analysis is:

  • analyze and evaluate the company's financial situation from different perspectives
  • determine the impact of past decisions or activities
  • compare the actual results with the financial plan, actuals, other entities, industry or national average
  • derive trends

 

In order to:

  • identify risks and weaknesses, on the minimization of which the entity should focus (possible input into the SWOT matrix)
  • identify strengths and opportunities, which the entity could use (possible input into the SWOT matrix)
  • learn from the past and take certain action or decision
  • prepare a plan for the next period


Can financial analysis by itself evaluate financial health of the entity?

Financial analysis significantly helps evaluate the company's financial situation. However, it is necessary evaluate other information as well. This information can include:

  • Internal information:
    • the notes to the financial statements
    • tax situation of the company (tax returns)
    • events happened after the end of the reporting period
    • the auditor's opinion
    • maturity structure of assets and liabilities etc.

 

  • External information:
    • macroeconomic conditions - recession/boom, inflation, exchange rate, GDP and GDP growth, taxation and interest rates, unemployment rates, availability of credit
    • political conditions - e.g. consumer protection, subsidies, tax rates, social and and health insurance paid by employers
    • legislative conditions
    • social conditions - e.g. the demographic structure, crime-rate, fashion
    • current and expected development in the markets in which the company operates - e.g. new competitors and substitute products

Inputs to financial analysis

The main inputs to financial analysis are financial statements - mainly balance sheet, statement of profit and loss, cash flow statement and notes to the financial statements or more detailed accounting data.

Other possible inputs may include:

  • data from intracompany/management accounting
  • budgets, forecasts or various plans
  • (expert) estimates etc.

But the quality of the output of the financial analysis will be the result of the quality of the inputs to it. So be careful when using less credible source such as estimates.

So if estimates or any adjustments (e.g. for the extraordinary operations, which will not be repeated in the future) form an important item, it is advisable to note in the related materials (reports prepared for the bank or internally) that the estimates were used and in what amount to enable the user to evaluate their relevance.

 

You can come across a few questions in the area of inputs to financial analysis. For example:

 

1. What data accounting data should be used – those prepared in accordance with national legislation and IFRS (US GAAP)?

 

It always depends which set better reflects the economic reality, the purpose for which the financial analysis is prepared, what are the specific requirements of users of financial analysis and so on.

However, IFRS (or US GAAP) often captures the economic reality more accurately than national legislation, especially through the principle of "substance over form" which gives priority to the economic substance of the transaction prior to its legal form.

In addition, already from their titles can be derived that they are either generally accepted (GAAP = Generally Accepted Accounting Principles) and international (IFRS = International Financial Reporting Standards), so they should enable international comparisons.

 

2. What accounts shall be included in the financial analysis?

The inputs to the financial analysis are not always just summarization of certain items in the financial statements and general ledger accounts. Some entries may come from outside the accounts or you will need to use only a certain part of the specific account.

But even in cases where it is possible to use only the statements or ledger accounts, you need to have in mind that the firm should show on these accounts only what is really supposed to be shown  and vice versa – that the summarization of certain accounts will secure the entire input to the financial analysis formula.

The reason for this disunity is the fact that each entity may include different transactions in certain accounts (of course, under applicable accounting rules).

 



Basic steps during preparation of financial analysis

 

1. Setting the objectives and users of financial analysis - to make it clear what will be its main focus.

2. Selection the appropriate methods and indicators. There is a wide range of indicators and some are used more than others. However, it is certainly not desirable to calculate and analyze all of them. Not only because they are often interrelated, but such analysis would be very confusing. Indicators are usually chosen consistently over longer period of time and the purpose of use. We mark the most important indicators on this website with (!).

3. Selection of appropriate inputs and their possible adjustment, e.g. for extraordinary operations, which will not be repeated in the future.

4.  The calculation (including basic logical checks!)

5. Analysis and interpretation - the hardest part. It may include various comparisons of the calculated figure – please see the article about general comparatives used in financial analysis.

6. Ascertainment of interrelationships between indicators.

7. Ascertainment of the causes of the differences - no indicator can be looked at individually without context with other indicators.

8. Breakdown of variances into controllable and uncontrollable (e.g. inflation, new legal standard, fashion).

9. Development of conclusion and recommendations for the future.

10. Summary of all the points mentioned above (e.g. into a report). This may, in addition to standard components,  include:

  • recipients of the financial analysis and the main purpose
  • used inputs (periods, source etc.)
  • overview of adjustments of the original inputs (e.g. adjustments of the financial statements for extraordinary items, which will not repeat in the future)
  • indicators broken down into categories and their absolute and relative comparisons (e.g. with the previous period)
  • explanation of whether the deviation is significant or insignificant
  • identify the main causes of deviations
  • explain the impact on the future of the company and users of financial analysis
  • summarizing the results of the financial analysis as a whole
  • suppose corrective action and recommendations for the future
  • contact for a person, who prepared the financial analysis (in case of subsequent questions)
  • date of processing.

 


Benchmarks in financial analysis

Calculated values ​​can be compared with:

  • recommended values
  • historical development - with previous years or the average over a certain period
  • budget or plan
  • competitive company
  • sectoral or national average
  • other parts of the entity, other companies within a group or groups of entities


Common problems with financial analysis

Problems with inputs that will influence also the quality of the output from the financial analysis:

  • financial statements are prepared with a certain time lag (usually up to 6 months), the current situation can already be different
  • financial statements include the results of ad-hoc transactions that will not repeat in  the future
  • various methodologies used in accounting (e.g. inventory accounting method A or B, different methodology for provisioning, etc.)
  • objects in the balance sheet usually contain historical values rather than the current prices (i.e. the results can be distorted e.g. due to inflation)
  • closing balances in accounting may not correspond to economic reality - e.g. exceptionally high receivable, which was not paid by the end of the year or the acquisition of assets at the end of the accounting period when the balance sheet already shows assets and liabilities, but the property has not yet started to generate revenues
  • quality factors, such management competence and staff qualifications as  are not measured
  • financial statements (mainly profits) can be manipulated so that the results look better (so called window dressing)
  • intra-group transactions (e.g. trading at non-competitive prices or certainty of sales)
  • profit does not equal the cash-flow, the cost does not equal the expenditure and revenue does not equal the receipts
  • the use of estimates that may not be accurate

 

Problems with comparisons

  • there are no generally recommended values ​​for all indicators
  • recommended values do not necessarily be valid in every industry and entity and as such, it is difficult to deduce the ideal values
  • sectoral or national averages and values achieved by competition are often not available; or possibly, this data is only available for different periods or lack the basic assumptions, etc.
  • data for the previous periods are not available and as such, it is not possible make comparisons within the same entity over time (e.g. new company, significant changes etc.)
  • different divisions and companies within the group are not comparable
  • seasonality - when comparing month to month

Methods of financial analysis and its indicators

Classification of financial analysis methods according to the objects covered:

 

Methods of financial analysis according to the calculation method:

  • analysis of absolute indicators
  • analysis of differential indicators
  • analysis of financial ratios
  • group of indicators

(9, p.12)

 

Financial analysis indicators can be classified into the following basic groups:



METHODS OF FINANCIAL ANALYSIS ACCORDING TO THE OBJECTS COVERED


Horizontal analysis

Horizontal analysis is the method of financial analysis, which shows the changes (ratio or difference) of the same item over time (e.g. a comparison of total assets at the end of the reporting period compared to the end of the previous year).

 

It is possible to compare to:

  • the previous period (the most common), e.g. with the previous year
  • the selected period, e.g. with a year three years back
  • with an average of several previous periods, e.g. average for the last 3 years

 

It can be shown as

 

  • difference of the same indicator in the financial statement over time (i.e. the absolute change):

 

  • ratio of the same indicator to the value of the previous period 

 

  • ratio of the difference of the same indicator from the value of the previous year to the value of the previous period  (i.e. the relative change):

 

calculation, if the values ​​in the period t-1 are positive

 

simplified calculation, if the values ​​in period t-1 is negative (the denominator multiplied by -1)

                       Note: This calculation is more complicated, but in practice, you can often well do just if the excel function "IF" on these two                                       options.

 (9, p. 14)

 

Purpose of horizontal analysis

  • identifies the items with the highest absolute or relative change
  • helps derive trend
  • enables comparison of the percentage change in the output items compared to the percentage change in the input items → % changes in items of outputs (e.g. profit, sales) should generally be higher than in items of inputs (e.g. inventory, number of employees, wages), however, it also depends on the intentions of the company (9, p.16)

 

Disadvantages of horizontal analysis

  • values ​​for the previous period may not be available (new company, new product, different methodology for reporting the same item, etc.).
  • ratio cannot be calculated if the value of the previous period is zero
  • if the values for the previous period are negative, the formula for calculating the relative deviation must be adjusted
  • it is necessary to understand the signs, (e.g. whether + 10% means an increase or decrease in costs)


Vertical analysis

Vertical analysis is the method of financial analysis, which is used to calculate the ratio of certain item on a summary item, for example % of inventories on current or total assets.


Methods of financial analysis according to the calculation

Analysis of absolute indicators

Analysis of absolute indicators is used to assess the absolute level of various items, e.g. the amount of assets, equity and debt capital, profit, revenue, number of employees, etc. It is used primarily to compare the size of the monitored companies with other companies and classification of the company into a certain type (e.g. capital intensive company).

 

Analysis of differential indicators

Analysis of differential indicators is used to calculate and analyze the difference of certain items. It includes e.g. the analysis of:

 

Ratio analysis

Ratio analysis is formed by the ratios of certain items from the financial statements and is the most common method of financial analysis.

The results may be shown either as an index (e.g. 0.1) or more frequently in % (e.g. 10% which is index x 100).



Basic groups of financial analysis indicators


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