What is financial analysis for?

Financial analysis is a tool used by existing and potential shareholders of a company, as well as lenders or rating agencies. For shareholders, financial analysis assesses whether the company is able to create value. It usually involves an analysis of the value of the share and ends with the formulation of a buy or a sell recommendation on the share. For lenders, financial analysis assesses the solvency and liquidity of a company – i.e., its ability to honour its commitments and to repay its debts on time.

We should emphasise, however, that there are not two different sets of processes depending on whether an assessment is being carried out for shareholders or lenders. Even though the purposes are different, the techniques used are the same, for the very simple reason that a value-creating company will be solvent and a value-destroying company will sooner or later face solvency problems. Nowadays, both lenders and shareholders look very carefully at a company’s cash flow statement because it shows the company’s ability to repay debts to lenders and to generate free cash flows, the key value driver for shareholders.

Financial analysis is more of a practice than a theory

The purpose of financial analysis, which primarily involves dealing with economic and accounting data, is to provide insight into the reality of a company’s situation on the basis of figures. Naturally, knowledge of an economic sector and a company and, more simply, some common sense may easily replace some of the techniques of financial analysis. Very precise conclusions may be made without sophisticated analytical techniques. Financial analysis should be regarded as a rigorous approach to the issues facing a business that helps rationalise the study of economic and accounting data.

It represents a resolutely global vision of the company

It is worth noting that, although financial analysis carried out internally within a company and externally by an outside observer is based on different information, the logic behind it is the same in both cases. Financial analysis is intended to provide a global assessment of the company’s current and future position. Whether carrying out an internal or external analysis, an analyst should endeavour to study the company primarily from the standpoint of an outsider looking to achieve a comprehensive assessment of abstract data, such as the company’s policies and earnings. Fundamentally speaking, financial analysis is thus a method that helps to describe the company in broad terms on the basis of a few key points.

From a practical standpoint, the analyst has to piece together the policies adopted by the company and its real situation. Therefore, analysts’ effectiveness are not measured by their use of sophisticated techniques, but by their ability to uncover evidence of the inaccurateness of the accounting data or of serious problems being concealed. As an example, a company’s earnings power may be maintained artificially through a revaluation or through asset disposals, while the company is experiencing serious cash flow problems. In such circumstances, competent analysts will cast doubt on the company’s earnings power and track down the root cause of the deterioration in profitability.

We frequently see that external analysts are able to piece together the global economic model of a company and place it in the context of its main competitors. By analysing a company’s economic model over the medium term, analysts are able to detect chronic weaknesses and to separate them from temporary glitches. For instance, an isolated incident may be attributable to a precise and nonrecurring factor, whereas a string of several incidents caused by different factors will prompt an external analyst to look for more fundamental problems likely to affect the company as a whole.

Naturally, it is impossible to appreciate the finer points of financial analysis without grasping the fact that a set of accounts represents a compromise between different concerns. Let’s consider, for instance, a company that is highly profitable because it has a very efficient operating structure, but also posts a nonrecurrent profit that was ‘‘unavoidable’’. As a result, we see a slight deterioration in its operating ratios. In our view, it is important not to rush into making what may be overhasty judgements. The company probably attempted to adjust the size of the exceptional gain by being very strict in the way that it accounts for operating revenues and charges.

Economic analysis of companies

An economic analysis of a company does not require cutting edge expertise in industrial economics or encyclopaedic knowledge of economic sectors. Instead, it entails straightforward reasoning and a good deal of common sense, with an emphasis on:

• analysing the company’s market;
• understanding the company’s position within its market;
• studying its production model;
• analysing its distribution networks; and
• lastly, identifying what motivates the company’s key people.

Analysis of the company’s market

Understanding the company’s market also generally leads analysts to arrive at conclusions that are important for the analysis of the company as a whole.