A global food group's reported return on equity climbed from 17.7% to 22.0% over two years while the business its managers actually control got measurably worse. Both facts come from the same audited statements. Finding the second one is the whole job.
Financial analysis is a means to an economic decision: lend or don't, buy or don't, affirm the rating or cut it. The tools follow from that decision. A six-phase framework keeps the work ordered.
- Phase 1, define purpose and context: state the objective (value equity on comparables, critique a credit rating, build a comprehensive picture of financial leverage, test the perspectives in management's discussion...
- Phase 2, collect input data: statements, notes, management commentary, industry and economic data, questionnaires, discussions with management, suppliers, customers, and competitors, and site visits.
- Phase 3, process the data: adjusted statements, common-size statements, ratios, graphs, forecasts.
- Phase 4, analyze and interpret: convert processed data into analytical results. Phases 3 and 4 in practice run together.
Common mistakes
- Leaving associates in the margin. Dividing total net income by sales gives 16.27% for a business whose own operations earn 7.53%. Income from associates has no revenue attached.
- Adjusting leverage for associates. Strip the investment from assets for turnover, but leave the leverage ratio alone; the same funding mix supports both asset pools.
- Reading a stable leverage ratio as a stable capital structure. Leverage held between 1.87 and 1.98 while long-term financial debt rose from 7.8% to 12.3% of long-term capital.
Bottom line
- Six phases: define purpose, collect data, process data, analyze, communicate conclusions, follow up; Phases 3 and 4 run together
- Purpose selects technique; credit work targets coverage and obligations, valuation work targets normalized comparable earnings
- Five-way ROE: tax burden × interest burden × EBIT margin × asset turnover × leverage
- Associates adjustment: subtract associates' income from net income and the investment from assets; leave leverage unadjusted
Exam shortcut
Read the stem for the decision first, then pick tools; if it says credit rating, ignore the equity-multiple machinery. Any vignette that shows a large post-tax "income from associates" line is asking you to subtract it from net income and subtract the investment from assets before computing margin and turnover, never from the leverage ratio.
The full lesson (about 2,310 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- integration techniques
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