Financial Analysis Definition

financial analysis definition

Let's begin by having you use your interpretive abilities on the five proportional balance sheets shown in table no. 01 on in this post. They give the financial analysis definition and percentage breakdown of accounts on the balance sheets of Merck & Co. (an ethical drug company headquartered in New Jersey), FPL Group (the parent for Florida Power and Light, an electric utility headquartered in Miami), Bank America Corporation (commercial bank based in San Francisco), J.C. Penney Company (retail department store chain based in Dallas), and Dow Chemical Company (a chemical company based in Michigan). As you can see, the table does not indicate which corporation goes with each set of financial statement information. That's your assignment, determine which balance sheet, A through E, goes with which company.

Incidentally, since bank financial statements are different from those of nonfinancial businesses, we altered Bank America's statement slightly. We classified the bank's loans as accounts receivable and we classified its deposit liabilities as accounts payable.

How did you do?

Company A is Bank America. This company has a large investment in bank loans ( accounts receivable) and owes a lot of accounts payable (deposit liabilities). Compared to the other companies, Bank America has a large investment in cash and marketable securities and very little invested in inventories or in fixed assets. This bank, like other banks, has very little stockholder's equity compared to nonfinancial businesses. Banks rely very heavily on debt financing.

Company B is FPL Group, the electric company. This is apparent because of the large investment in long term assets, the generating and transmission facilities that electric companies must have. FPL Group has very low receivables and inventory, too. Because they provide an essential service and have a degree of monopoly power in their service areas, public utilities have been fairly low risk companies. This has allowed them to use debt financing very heavily. You can see that FPL Group has fairly high long term debt and modestly low shareholder's equity.

Company C is J.C. Penney. The giveaway is that, as a retailer, J.C. Penney should have much more invested in receivables and in inventory than the other companies.

This leaves Companies D and E, and Merck and Dow. If you don't know which is which, here's a clue. Merck is in a riskier business than Dow. Drug companies risk a 

Table No. 01

Tremendous amount on the success of new drugs they develop and introduce. If its new drugs are unsuccessful or are delayed, a drug company can be in serious jeopardy. Consequently, drug companies employ two important risk management strategies that are apparent in table no. 01. First, drug companies maintain relatively large cash balances. Such a balance would allow them to operate for a long time in the face of revenue shortfalls. Second, drug companies try to minimize the fixed interest obligation associated with debt financing. As you can see, Company D holds much more cash and equivalents than Company E. Company D also uses much less long term debt financing and has a much greater stockholders equity than Company E. In fact, Company D is Merck and Company E is Dow.

As the Behavioral Principle predicts, obvious differences among companies in different industries can emerge from a careful reading of their financial statements. More detailed financial statement analysis, however, can be a costly exercise. Therefore, you should not undertake this work unless you expect its benefits to outweigh its costs. This leads to the questions of who uses financial statement analysis, why do they use it, and how do they use it? Some answers include.

1. Equity investors. Investors use financial statement analysis to help them decide whether to buy, sell, or hold particular common stocks.
2. Creditors. Long term lenders use financial statement analysis to decide which bonds to invest in. Short term lenders use this information when deciding to make short term loans or to purchase money market instruments.
3. Management. Managers use financial analysis to help make decisions about resource allocation or about mergers and acquisitions. Financial statement analysis is also used to evaluate and reward the performance of various managers. As a manager, your raises, your promotions and even your termination can depend on meeting certain financial targets.
4. Other professionals. Auditors use financial statement analysis to supplement some of their audit procedures. The Internal Revenue Service reviews the structure of financial statements to help determine the reasonableness of tax reports. Government and regulatory agencies use it to monitor and regulate companies in many industries. Labor unions carefully review the financial health of employers When they engage in collective bargaining. Marketing managers use this information to enhance the marketing of their companies goods and services. Customers are very concerned about product quality or when ever they need a long term dependable supplier.
5. Students. Job seekers use financial information both to learn as much as possible about prospective employers and to help them display their knowledge and talents to recruiters. Students often conduct financial analysis definition to help them avoid an economic phenomenon commonly known as unemployment.