Framework for financial analysis


A number of different approaches might be used in analyzing a firm. Many analysts have a favorite procedure for coming to some generalizations about the firm being analyzed. In this article we present a conceptual framework that lends itself to situations in which external financing is contemplated.

The factors to be considered are as under,

Taking them in order, our concern in the first case is with the trend and seasonal component of a firm’s funds requirements. They are the quantum of funding that will be required in the future, and the nature of these needs. One must also look into the fact whether there is a seasonal component to the needs.

Analytical tools used to answer the points highlighted above include sources and uses of funds statements, statements of cash flow, and cash budgets, all of which are considered. The tools used by the financial analyst to assess the financial condition and performance of the firm is the data which we are elaborating later in this article which offer valuable insight into the health of a firm—its financial condition and profitability.

Completing our first set of three factors is an analysis of the business risk of the firm. Business risk relates to the risk inherent in the operations of the firm. Some companies are highly volatile lines of business and / or may be operating close to their break-even point. Other companies are in very stable lines of business or / and find themselves operating far from their break-even point. A machine tool company might fall in the first category, whereas a profitable electric utility would probably fall in the latter. The analyst needs to estimate the degree of business risk of the firm being analyzed.

All three of these factors should be used in determining the financial needs of the firm. Moreover, they should be considered jointly. The greater the funds requirements the greater is the total financing that will be necessary. The nature of the needs for funds influences the types of financing that should be used. If there is a seasonal component to the business, this component lends itself to short-term financing, bank loans in particular. The firm’s level of business risk also strongly affects the type of financing that should be used. The greater the business risk, the less desirable debt financing and more through equity/stock financing. In other words, equity financing is safer because there is no contractual obligation to pay interest and principal, as there is with debt. A firm with a high degree of business risk is generally ill-advised to take on considerable financial risk as well.

The financial condition and performance of the firm also influence the type of financing that should be used. The greater the firm’s liquidity, the stronger the overall financial condition; and the greater the profitability of the firm, the more risky the type of financing that can be incurred. That is, debt financing becomes more attractive with improvements in liquidity, financial condition, and profitability.

The plan needs to be sold to outside suppliers of capital. The firm may determine that it needs $1 million in short-term financing, but lenders may not go along with either the amount or the type of financing requested by management. In the end, the firm may have to compromise its plan to meet the realities of the marketplace. The interaction of the firm with these suppliers of capital determines the amount, terms, and price of financing. These negotiations are often not too far removed from the type of haggling one may witness in an oriental bazaar—although usually at a lower decibel level. In any event the fact that the firm must negotiate with outside suppliers of capital serves as a feedback mechanism to the other factors.

Analysis cannot be undertaken in isolation from the fact that ultimately an appeal will have to be made to suppliers of capital. Similarly, suppliers of capital must keep an open mind to a company’s approach to financing, even if it is different from their own.

There are a number of facets to financial analysts which we have discussed above. Presumably, analysis will be in relation to some structural framework similar to that presented here. Otherwise, the analysis is likely to be loose and not lend itself to answering the question for which it was intended.