Types of Financial Analysis, part 2
Most people do not recognize that it wasn’t until the beginning of the Depression Era, the early 1930s, when the New York Stock Exchange mandated basically what we call today the matching principle: the accounting matching of revenues and expenses, as undertaken in the typical income statement, that a separate form of income determination apart from the balance sheet grew to general use. And so it was not until the Depression Era that the income statement, the matching principle, and the separate determination of net income gained ascendancy as the predominant form of financial analysis. Further, we can see why this would be the case at that time. During the Great Depression income was so scarce and hard to come by that its separate determination was called for. In the early 1930s, interest rates were extremely low, in some cases negative. Banks closed their doors in record numbers, and the power of bankers to influence the course of events was on the decline. Income analysis became more and more important, and net income analysis and the income statement predominated as a form of financial analysis. This persisted until relatively recently.
In the 1970s, with great inflation, income computations according to the traditional methods, with the use of historical costs, became a bit silly and meaningless due to the misapplication of valuation with respect to the balance sheet. The significant level of inflation made these historical costs less meaningful, and what was found on the balance sheet (basically historical cost determined assets that represented unexpired costs) went into the income statement as these costs expired. In that these costs were no longer a reflection of current valuation in a highly inflationary era, the balance sheet (which was already in considerable disrepute) went into even further decline as an analytical tool, and an understanding developed that the income statement was not very meaningful, either, without some adjustments. Accordingly, price level adjustments that had been developed for some time resurfaced as a means of enhancing the analytical use of both the balance sheet and the income statement.
Basically, the conditions of the time led to an understanding that neither the income statement nor the balance sheet was of much analytical value in dealing with the prevalent business environment. Different product costing techniques, such as LIFO, FIFO, and average, led to very different accounting results. Similarly, different depreciation techniques – straight- line, double declining balance, etc. – led to very different income statement and balance sheet results. And while new financial analytical methods were called for, it was really old techniques that were found to deal with the requirements of the times.
Cash flow analysis became more and more in vogue because of its ability to deal with the economic exigencies of the time and its lessened degree (as compared to the balance sheet and the income statement) of being subject to accounting manipulation by the preparers of financial statements in order to portray the desired results. Today, cash flow analysis truly is by far the most important kind of financial analysis, and most finance professors now deal with their students in terms of free cash flow (cash flow from continuing operations less capital expenditures and dividends) in that it leads to an enhanced ability to effectively analyze the firm, regardless of the level of inflation or the accounting techniques that are used. That is, free cash flow provides a far better handle on the solvency and productive operations of a firm than the income statement or the balance sheet. This is especially true in difficult and volatile economic times.
With the return of the ascendancy of cash flow analysis after many centuries have also come many alternative ways of understanding cash flow. Free cash flow is just one of them; there are others. It has been an interesting metamorphosis through the years. We’re back where we started at the dawn of the Industrial Revolution, with cash flow predominating as a financial analytical tool.
The high-profile bankruptcies of the 1990s and early 2000s have certainly helped bring about this change. Moreover, the financial bubble at that time, which in many ways reflects other such bubbles of other centuries, also reflects this – a need to get away from allowing businesses to tell us what they want to tell us and what they want us to believe they are worth. We have to look beyond some of the inherent misstatements in the balance sheet and the income statement and the amenability of these forms of financial analysis to manipulation by some unscrupulous financial managers who sometimes find it desirable to tell lies to cover misdeeds or poor financial performance. It is important that financial analysts employ techniques that will effectively determine the value of businesses they are studying.
Tags: Finance