FINANCIAL ANALYSIS : How to perform a financial analysis
The aim of financial analysis is to explain how a company can create value in the medium term (shareholders' viewpoint) or to determine whether it is solvent (lenders' standpoint). Either way, the techniques applied in financial analysis are the same.
First of all, financial analysis involves a detailed examination of the company's economics, i.e. the market in which it operates, its position within this market and the suitability of its production, distribution and human resources management systems to its strategy. Next, it entails a detailed analysis of the company's accounting principles to ensure that they reflect rather than distort the company's economic reality. Otherwise, there is no need to study the accounts, since they are not worth bothering with, and the company should be avoided like the plague as far as shareholders, lenders and employees are concerned.
A standard financial analysis can be broken down into four stages:
- Wealth creation (sales trends, margin analysis) …
- … requires investments in capital employed (fixed assets, working capital) …
- … that must be financed (by internal financing, shareholders' equity or bank loans and borrowings) …
- … and provide sufficient returns (return on capital employed, return on equity, leverage effect).
Only then can the analyst come to a conclusion about the solvency of the company and its ability to create value.
Analysts may use trend analysis, which uses past trends to assess the present and predict the future; comparative analysis, which uses comparisons with similar companies operating in the same sector as a point of reference; and normative analysis, which is based on financial rules of thumb.
Ratings represent an evaluation of a borrower's ability to repay its borrowings. Ratings are produced through a comprehensive financial analysis of groups, part of whose debt is traded on a market.
Scoring techniques are underpinned by a statistical analysis of the accounts of companies, which are compared with accounts of companies that have experienced problems, including bankruptcy in some cases. This automated process yields a probability of corporate failure. Scoring is primarily used for small and medium-sized companies.