Corporate Finance, 4th Edition

Chapter 8How to perform a financial analysis

Opening up the toolbox

Before embarking on an examination of a company's accounts, readers should take the time to:

• carry out a strategic and economic assessment, paying particular attention to the characteristics of the sector in which the company operates, the quality of its positions and how well its production model, distribution network and ownership structure fit with its business strategy;
• carefully read and critically analyse the auditors' report and the accounting rules and principles adopted by the company when preparing its accounts. These documents describe how the company's economic and financial situation is translated by means of a code (i.e. accounting) into tables of figures (accounts).

Since the aim of financial analysis is to portray a company's economic reality by going beyond just the figures, it is vital to think about what this reality is and how well it is reflected by the figures before embarking on an analysis of the accounts. Otherwise, the resulting analysis may be sterile, overly descriptive and contain very little insight. It would not identify problems until they have shown up in the numbers, i.e. after they have occurred and when it is too late for investors to sell their shares or reduce their credit exposure.

Once this preliminary task has been completed, readers can embark on the standard course of financial analysis that we suggest and use more sophisticated tools, such as credit scoring and ratings. ...