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115.040.06.01 Financial Analysis - Reading 24 - 1. Analysis Tools and Techniques

# 1. Analysis Tools and Techniques

## a. describe tools and techniques used in financial analysis, including their uses and limitations;

Ratios are useful for analysis of companies, but what are some of the limitations of ratios?
- A ratio is not "the answer", it is only the outcome of of past performance
- Differences in accounting policies can distort ratios between similar companies
- Not all ratios are relevant to all analyses
- A ratio is not the end, you must also interpret the result

What are four questions an analyst must ask themselves before relying on a ratio?
1. How homogeneous is the company? Many companies have multiple lines of business, making an overall ratio difficult to rely on.
2. Are the results of the ratio analysis consistent?An analyst needs to look at several ratios in conjunction in order to form a sensible conclusion. The total portfolio of the company should be used instead of only one set of ratios.
3. Is the ratio within a reasonable range for the industry? Analysts must look at a range of values for a particular ratio because a ratio can be too high or too low.
4. Are alternative companies' accounting treatments comparable?

What is a common-size analysis?
Common-size statements normalize balance sheet, income statement, and cash flow statement items to allow easier comparison of different-sized companies. They reduce all the dollar amounts to a percentage of a common amount.

What is a common-size balance sheet?
A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets.

What is a common-size income statement?
A common-size income statement expresses all income statement items as a percentage of sales.

What are the formulas for common-size balance sheets and income statements?
- $$Common-size\ BS\ ratios = \frac{balance\ sheet\ account}{total\ assets}$$
- $$Common-size\ IS\ ratios = \frac{income\ statement\ account}{sales}$$

What is a cross-sectional analysis?
Cross-sectional analysis compares a company to the industry or other comparable companies for a particular ratio.

What is a time series (trend) analysis?
Time series (trend) analysis compares a company's performance to itself over time to examine the trend of a particular ratio. It aims to detect changes in the company's operations over time.

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