A modern view of Financial Analysis

What is Financial Analysis?

In our view, Financial Analysis consists of:

Using, transforming and presenting financial information in meaningful ways to help you understand how efficiently you use money in the pursuit of your goals.

If your objective is to maximize the profits your company makes, then you would probably want to understand:

• If your business made more profits than in previous years.
• If your business is likely to continue to make more profits in years to come.
• If it has taken more or less resources to generate each monetary unit of profit.

But, what exactly are profits? Are we referring to the Net Profits appearing in an Income Statement? Could you trace that result back to monetary movements in your bank accounts? The answer is No.

Why? Because Financial Statements must adhere to tax laws and in doing so they introduce monetary distortions that skew financial analysis. The most important one being what Income Statements define as Net Profit.

Net Gains vs Net Profits

Income statements start with net sales and subtract costs to obtain gross profit. Subtracting expenses (excluding depreciation and amortization) gives operating profit (EBITAD). Until this point there are no distortions, unless tax laws do not recognize some of the expenses your company made. But assuming all expenses are recognized as valid, it is from this point onward where tax regulations have a major impact. The reason is that they require depreciation to be subtracted instead of capital expenditures. Subtracting depreciation and interests on debt, results in taxable income. If you compute the amount of taxes to be paid, then you can actually go back and take the Operating Profit and deduct capital expenditures, interests paid, income taxes, and principal debt to obtain your monetary traceable Net Gain. Notice that principal paid is not deductible either, and that is another source of distortions. What we have called Net Gain is also known as the Free Cash Flow.

As an example of how big the monetary distortion can be, let us consider the income statement for the fiscal year 2024 for an important well known public company: Apple.

The disparities will be bigger for companies that do not make capital investments on a yearly basis. It should be clear that the actual yearly net benefit is the 'Actual Net Gain' in the table above.

Therefore, You should use the per period Net Gain instead of the Net Profits from the Income Statements when analyzing a company's financial performance.

Current Financial Analysis

If profit maximization over time is your primary goal, what type of analysis should you perform?

Traditionally financial analysis has been limited to the study and interpretation of metrics in accounting statements. Among the most important ones are:

We recommend that you replace Net Income for Net Gain in the first two ratios. Actually, let us remark again that Net Gains are usually called Free Cash FLows.

What could those five numbers tell you?

The first two numbers, from left to right, basically tell you how good of an investment the business turned out to be in that period. The first one, in terms of the proportion of the assets purchased by the shareholders. The second, in per share terms.

The third number refers to the proportion of the current assets that were acquired through debt.

The last two numbers basically tell you about how easily you could pay off current debt.

What is missing? If you think about it, those numbers refer to a one period occurence that has already taken place or to an extreme case of being able to pay off debt. All of the ratios about either solvency or liquidity have to do with the future and rather than considering using current flows to meet obligations, look at the extreme position: could we pay off by selling our assets?

Could you really tell by looking at them if the firm is working efficiently towards an ongoing profit maximizing goal?

After all, you can always make the present look good by compromising future performance.

A New Approach to Financial Analysis

Contrast the information obtained from those ratios, with what you could learn about a company's prospects for generating net gains using the following graphs.

Using the Financial SandBox

The first chart shows the expected trend in revenue framed by the uncertainty bounds associated to an unknown future.

The second chart shows the expected free cash flows resulting from management's adherence to certain efficiency parameters that enable determining all cash out-flows.

The debt payments have been incorporated and the principal payments occuring at times 4 and 9 are easily identifiable. The first two ratios may be easily computed for the future years using the information in these two charts.

The third chart condenses future expected net benefits into the simple Net Present Value metric. Notice that the NPV is also shown in a context of uncertainty.

The fourth chart displays the probability distribution for the Net Present Value, asssociated to the uncertainty intervals.

In addition to those charts, we could easily estimate future Income estatements including a growth section at the bottom. See figure below. All the charts shown here may be generated in the Upgraded version of the SandBox menu item.

Additional analysis

The SandBox menu, in its upgraded version, enables comparing different scenarios capturing alternative management efficiency policies. For example, you may want to consider the impact on the company's value of eliminating debt, or of changing discounting rates.

However, what we would like to stress is that Financial Analysis should include any aspect of a company's business that may significantly impact the efficiency with which it is attaining its goals. Of course some analysis are more important than others, but certainly the ratios extracted from a single set of financial statements offer a very limited view.

To broaden your view, it may be relevant to consider what Finance does within an organization.

Finance

We think of Finance as:

The discipline that studies intelligent ways of using the transformative power of money, in helping you achieve your goals

When you buy resources, you turn money into those resources. You then use those resources to generate a good or service. Once that output is sold, it is transformed back into money. While that money is needed, it is typically invested. When money is needed, the investments are sold, debts and taxes are paid and the cycle begins again.

Finance follows the flow of money, its transformations into physical entities and back into monetary units. It analyzes potential risks involved in currency exchanges and the risks versus benefits associated to potential investments and how to transform them back to currencies required to make payments. It is dynamic in nature and analyzing a company's finances should try to incorporate that continuous change nature as much as possible.

From the above definition, you should consider analyzing any transformation from the monetary realm to the physical realm as well as any transformation from money to investments and to payments.

Because, all transformations are cyclical and periodic it would be in wise to update your metrics periodically.

Finnugget was designed to assist you in analyzing various monetary transformations in the business cycle.

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