Types of Financial Analysis, part 1
There are many types of financial analysis. You can almost call anything having to do with dollars financial analysis; as long as you’re dealing with a dollar sign, you’re engaging in some form of financial analysis.
A bit of history with respect to the relative emphasis of various forms of financial analysis or accounting statement types through the years might be useful at this at this point. There has been a very interesting change through the centuries in the focus of financial analysis and the relative importance of the various financial statements. Cash flow analysis was the predominant focus of financial analysis at the dawn of the Industrial Revolution. Businesses at that time, when they opened their doors, had to be sure they could last the day, and so they had to have cash to make change and sufficient liquidity to secure their other transactions. Basically, what was needed was sufficient cash to satisfy what economists like to call transaction demand and some security beyond this for purposes of what economics refer to as a precautionary demand for cash. So cash flow analysis is what was focused on at that time.
Businesses were simple; there was no complex manufacturing, where the determination of product costs and the requisite financial statements are very significant. Enterprises were predominantly simple, service-type businesses: trading and very rudimentary manufacturing, and such.
Then, in the early 1800s, what was then Britain (United Kingdom now) passed what were known as the Company Acts. The British Company Acts mandated the compilation of something pretty close to what we now know as the balance sheet, and that changed the focus from a cash flow analysis to a balance sheet analysis. This change was prompted by banks, which understood borrowing customer solvency in terms of a relationship between assets and liabilities; hence an emphasis upon the balance sheet.
Bankers are now far more intelligent and sophisticated in financial affairs, understanding that it is really income and basically cash flow that will repay their loans. But bankers at that time wanted to look at balance sheets. They believed that in the event of the insolvency of their borrowers, they could proceed against the physical assets of these borrowers and wished to know the book values of these assets, as well as the amount of claims standing in line with them for satisfaction. This knowledge required balance sheets prepared on the basis of historical costs. So income, while of some importance as a measure of business stability and success at the time, was of secondary consequence and was computed indirectly.
You would determine net income in those days according to what is now referred to as the net worth method. The net worth method of net income determination is basically as follows: you compute net worth at the beginning and at the end of the year (Assets – Liabilities = Net Worth), as found on the balance sheet, compare these two net worth figures, add back a capital consumption allowance (depreciation), and you have your net income for the year. Accordingly, net income was not computed directly at the time as is done today, but was ascertained as a derivative from the balance sheet. This was because, as noted, at the time net income was of secondary importance, and cash flow was of even less consequence.
As time went on and there were financial upheavals and monetary panics aplenty on both sides of the Atlantic, investors and bankers began to realize the limited nature of the net worth method, not only for an accurate determination of net income, but also as a gauge in determining expected business solvency. Change in the focus of financial analysis and the relative importance of the various financial statements and income determination methods was on its way. However, it is interesting to note how long it took before a fundamental alteration took hold in the emphasis placed upon the various types of financial analysis.
Tags: Finance