The financial analyst employs a broad range of methods and techniques for company analysis. Like a mechanic, he selects the tool that most suits his needs. Some of the most popular methods are computationally simple and can be applied by just about everyone. Understanding some of these tricks of the trade is important for analyzing companies you may be interested in investing in or for analyzing your own business.
Horizontal analysis compares financial results over time. A financial statement analyst compares income statements or balance sheets for subsequent years to uncover trends or patterns. While useful, but this method has drawbacks as well. For example, one-time accounting charges such as expenses for impairment, losses from natural disasters and changes in company structure can impede accurate analysis.
Vertical, or common-size, analysis prepares financial statements that are adjusted as percentages of sales or other account category totals. This technique allows analysts to see the compositions of the different categories of financial statements. On the income statement, sales is commonly used as the reference category and is the denominator of all of the other calculations; the balance sheet uses total assets, total liabilities and total equity. The downside of vertical analysis is that it only offers a look at a single period of operations, generally a year. This can make it difficult to draw conclusions about the business over time.
Financial analysts use a broad range of techniques that are collectively known as ratio analysis. The general procedure involves calculating various financial ratios -- such as profit margin, accounts receivable-to-sales, and inventory turnover ratios -- and comparing them to other companies or general rules of thumb. There are hundreds of financial ratios employed and even different methods of calculating the same ratios. For this reason, ratio analysis is considered to be more of an art than a science. This inconsistency is one of the technique's downfalls.
A technique often used both with ratio analysis and vertical analysis is benchmarking, which computes common-size financial statements or financial ratios and compares them with other companies and industry standards. This technique is popular and is sometimes used to compare a company to its competitors. However, it is important to note that every company is different; even companies in the same industry may have very different management philosophies, goal and cost structures. As such, benchmarking can be an effective tool, but might not be appropriate for ranking or directly comparing firms.
- Managerial Accounting: 12th Edition; Ray Garrison, et al.