Financial analysis, though varying according to the particular interests of the analyst, always involves the use of various financial statements - primarily the balance sheet and income statement.
The balance sheet summarizes the assets, liabilities, and owners' equity of a business at a point in time, and the income statement summarizes revenues and expenses of a firm over a particular period of time.
International and national accounting standard setters, are working toward "convergence" in accounting standards around the world. "Convergence" aims to narrow or remove accounting differences so that investors can better understand financial statements prepared under different accounting frameworks.
A conceptual framework for financial analysis provides the analyst with an interlocking means for structuring the analysis. For example, in the analysis of external financing, one is concerned with the firm's funds needs, its financial condition and performance, and its business risk. Upon analysis of these factors, one is able to determine the firm's financing needs and to negotiate with outside suppliers of capital.
Financial ratios are the tools used to analyze financial condition and performance. We calculate ratios because in this way we get a comparison that may prove more useful than the raw numbers by themselves.
Financial ratios can be divided into five basic typeliquidity, leverage (debt), coverage, activity, and profitability. No one ratio is itself sufficient for realists assessment of the financial condition and performance of a firm. With a group of ratios, however, reasonable judgments can be made. The number of keratios needed for this purpose is not particularly large - about a dozen or so.
The usefulness of ratios depends on the ingenuity anc experience of the financial analyst who employs them By themselves, financial ratios are fairly meaningless; they must be analyzed on a comparative basis. Comparing one company with similar companies and industry standards over time is crucial. Such a comparison uncovers leading clues in evaluating changes and trends in the firm's financial condition and profitability. This comparison may be historical, but it may also include an analysis of the future based on projected financial statements.
Additional insights can be gained by common-size and index analysis. In the former, we express the various balance sheet items as a percentage of total assets and the income statement items as a percentage of net sales. In the latter, balance sheet and income statement items are expressed as an index relative to an initial base year.