Financial analysis

The essentials

Financial analysis is the process of studying the relationship between items of financial statements to judge a firm's financial strength and weakness. Raw figures alone tell little; analysis converts them into meaningful information for decision-making by management, investors, creditors, lenders, employees and the government.

Key points

• Objectives: assess earning capacity (profitability), short-term liquidity, long-term solvency, efficiency of operations, and growth potential; compare with other firms and with past years.
• Significance: helps lenders judge repayment capacity, investors judge returns, and managers plan and control.
• Horizontal analysis: compares figures of several years (comparative statements); it is dynamic analysis.
• Vertical analysis: compares items within one year's statement against a base (common-size statements); it is static analysis.
• Tools: comparative statements, common-size statements, ratio analysis, cash flow analysis, trend analysis.
• Limitations: based on historical data; ignores changes in price level; ignores qualitative factors (such as staff morale and management quality); affected by personal judgement and differing accounting policies; may be distorted by window dressing.

Exam tips

Learn the limitations with one example each. Expect questions asking which user is mainly interested in which aspect (for example, short-term creditors and liquidity).

Common mistakes

• Calling common-size statements horizontal analysis. They are vertical analysis.
• Thinking financial analysis captures qualitative factors such as employee skill.