Financial Analysis Techniques Every Accountant Should Know
Financial analysis is an often-overlooked role for accountants, but an increasing number of companies are turning to accountants to provide deep insight into the financial health of the business. Through an analysis of change over time and an understanding of the inner workings of the company’s balance sheet, accountants are able to create a clearer picture of a company’s finances than analysts from other disciplines.
Accountants use a set of standard analytical tools as the foundation of their assessment, giving them a base from which to begin their work.
The first and easiest tool to use is an analysis of the company’s historical data. Also known as trend analysis, the practice involves an examination of the company’s financial statements and balance sheets over a period of at least two years. The accountant is looking for red flags, such as a steadily rising cost of operations or a revenue plateau.
Pros: Use of historical data show how a company performs over a long period of time. Healthy companies trend toward growth, and accountants are able to see growth potential, even during a temporary downturn. The application of trend analysis for historical data rewards companies that have a proven track record of success.
Cons: Historical analysis is really only useful if the company has more than two years of financial data. Young companies and startups lack the history needed for proper historical analysis. In addition, historical trends can be deceiving, especially for older companies that do have a history of success. The trends may indicate a temporary downturn, when the company is, in fact, in a steep decline.
Another simple tool of analysis is the calculation of profit ratios for the company. In general, companies use four different profit ratios in their financial statements; gross, operating, pretax and net. Each represents a unique stage in the search for profitability. Gross profits compare income to the cost of goods sold, taking into account material and manufacturing costs. Operating margin provides a clearer picture of profitability by including operating expenses and overhead into the calculation, and pretax profits show a company’s revenue in relation to its tax liability. Net profit is the ratio of income to all possible expenses and liabilities.
Pros: Profits are the “bottom line” for a business for a reason—they are what matter the most. An analysis of a company’s profitability is a straightforward answer to any question about a company’s health. A growing company has a positive profitability ratio, and a company that is struggling typically has a negative ratio.
Cons: Profitability only takes a look at money coming in versus money going out, and does not account for the accumulation of assets or the payment of debt. A company that invests heavily into new equipment may have an artificially low ratio for a given period, while a company that is borrowing regularly may show an unusually high ratio. Profitability is a tool that should be used in conjunction with other forms of analysis in most cases.
The limitations of profitability ratios necessitated the development of new analytical tools, leading to the rise of solvency calculations. Accountants arrive at the solvency ratio by dividing net income and depreciation by the company’s total liabilities, both short term and long term. Companies with a ratio of 20 percent or more are generally healthy.
Pros: Solvency is a better indicator of overall health than profitability calculations, because the ratio includes debt in the equation. Analysts can determine whether or not the business has enough income to fulfill its debt obligations, and pay its operating expenses to remain solvent.
Cons: Solvency and debt loads vary wildly from one industry to another, so comparing companies can be difficult. Also, the use of net income in calculations gives companies with high depreciation a lower ratio than they deserve, causing many accountants to prefer cash flow rather than net income in the equation.
Return On Equity
Large companies with many shareholders use a return on equity calculation for their financial analysis. The formula divides total net income by the average equity of shareholders. High numbers indicate that the company earned money on the investment, and shows investors that their money is properly utilized. Healthy companies have return on equity ratios of about 15-20 percent.
Pros: Profitability and other calculations are good for determining the health of the company, but investors are more concerned with whether or not their money is making money, and a return on equity analysis gives them an answer.
Cons: Return on equity is easy to manipulate, especially because of the lack of debt accountability in the equation. Companies that take on large debt loads can present high return on equity ratios, even though their financial health is in question. This is the reason why accountants use return on equity in conjunction with other accounting tools.
Accountants use common-size analysis to compare lines on a financial statement to a predetermined base, usually a percentage of total assets or net income. The purpose of this type of analysis is to allow accountants to compare companies of different sizes, or to compare changes year-to-year within the same company.
Pros: By using percentages rather than gross dollars, accountants have a clearer picture of expenses and liabilities than with other analytical tools. Seeing that one line of the statement is out of proportion with the others creates a sound starting point for change, and helps the accountant develop new strategies to improve the health of the business.
Cons: Not every company uses the same accounting practices or principles, so comparing lines on the financial statement between companies can be a bit misleading. While the differences in accounting practices do affect comparison to competitors, it is not a hindrance to the use of common-size analysis of a company’s own data.
Accountants play an important role in determining the health and financial stability of companies for shareholders and management. Through the deployment of a series of analytical tools, accountants gain insight into the past, current and long-term stability of the company, and can provide solutions to financial problems.
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Return On Equity