Use the framework for analysing financial statements
The idea
The framework runs in six steps: state the purpose and context of the analysis, collect the data, process it into ratios and common-size statements, analyse and interpret the processed data, develop and communicate conclusions, and follow up. The first step does most of the work, because the purpose determines which figures matter — a lender assessing a two-year facility and an equity investor assessing a decade care about different things in the same statements. The last step is the one most often skipped, and skipping it means a conclusion is never tested against what subsequently happened.
A practice question
What is the first step in the financial statement analysis framework?
- Collecting the financial dataWhy not: The second step, and one that goes badly without the first — collecting before knowing what for is gathering rather than analysis.
- Stating the purpose and context of the analysis — correct
- Computing ratiosWhy not: Part of processing, further down again. What to compute depends on what question is being answered.
The purpose determines what data is relevant and which measures matter. Beginning with collection means gathering without knowing what for.
A harder one
A lender and an acquirer analyse the same company. What differs first?
- The accounting standards appliedWhy not: Fixed by the preparer and identical for both readers.
- The audited figures available to eachWhy not: Both work from the same published statements. What differs is the question they bring to them.
- The purpose, which then decides which figures matter — correct
The inputs are identical. The lender asks about servicing over two years and the acquirer about earning power over ten, and those questions weight the same statements differently.
The hardest tier
An analyst begins by pulling five years of ratios before asking what the work is for. What is the risk?
- The ratios will be computed incorrectlyWhy not: They may well be computed perfectly. The waste is that correct figures can still be the wrong ones for the decision.
- Effort goes into figures that do not bear — correct
- The data will be out of dateWhy not: Five years of history is normal and useful. Age is not the problem; relevance is.
The ones that do bear on the decision may be missing altogether. Collection without a purpose is gathering rather than analysis, and the framework puts purpose first because it decides what is worth collecting.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →