Welcome back to The Language and Tools of Financial Analysis. In this second module, we will introduce an intuitive understanding of financial analysis. We will be drawing on knowledge from the first module, where we introduced financial statements, the balance sheet, and the profit and loss statement for our corporation. We will focus our discussion on profitability analysis but we will also take a look at some of the risk analysis that financial analysts perform. So, let's get crunching. What an analyst does is study and analyse companies, corporations, in order to arrive at a comprehensive determination of the company's overall financial worth, probably reflected in the balance sheet, and its performance. So financial analysis does more, than just reproduce balance sheet and profit and loss statement. Analysts take that information and look at the complete financial value of a corporation by scrutinizing those statements. And then supplement that information, the numerical information that you've now also got at your fingertips by having extensive discussions with management to get a better understanding of the line items on the profit and loss statement. Also get a better understanding of any off balance sheet transactions that might have taken place. Or any of those material events that might have occurred over the past year that are represented, reflected in the notes to the profit and loss statement. Having gathered all that information, the analysts will then regroup, work together to arrive at, let's call that a mosaic of information. Bringing all the pieces of information, both financial value information as well as the narrative that comes along with those financial statements. And they then pursue one of two ways. Usually they do both. They compare the performance of the corporation over time. They compare the evolution of the balance sheet, the financial position of the firm over time to get a good indication of what we could label absolute performance. Performance judged on its own. On its own, because it would reflect management's decision over the past year according to the profit and loss statement, or the longer term, as it is reflected on the balance sheet. It would also capture the life cycle of the firm. You'll see that there are quite distinct outcomes for firms that have only just started their operations. First there are firms that have been around for well over 100 years, like Kellogg's. And the state of the business cycle we're in. So time series information on profits, on net income of a corporation, will probably give a good indication of what stage of the business cycle a corporation is in. Lastly, what this type of analysis, horizontal analysis as it is also known, will capture is historical performance. Why would we be so interested in what happened in the past? Well, there's a suggestion in finance that past performance is a good indicator of future performance, and that is what analysts want to get their finger on. Analysts not only want to assess what has happened in the past on the basis of those financial statements and the corporation's narrative, they will want to extrapolate that information into the future. And finance theory will tell us that a good starting point would be its most recent performance. Whether that is truly the best guide is an entirely different method that we will discuss in the future. So here is just one little example of a time series of performance. What I've taken here is the return on equity for a representative corporation. And have traced the return on equity, the return to the shareholders over a 11-year period. And just to indicate that this is indicative of performance throughout the business cycle, you can see that the returns on equity took a bit of a beating around the global financial crisis, after which they started recovering. So this will give us some indication of how the firm went, and also allows us to assess poor performance in 2008 and 2009 against our knowledge of what happened in global financial markets. Most firms would have taken a battering over that time period, so maybe it is not management which is entirely to blame. So, how does this horizontal analysis work in practice? Well, what I've done here is simply take two balance sheets for two successive financial years, 2014 and 2013. What you see is that in 2013, equity was at $3.6 billion. And then, in 2014, equity had deteriorated to $2.85 billion. So that will suggest to the financial analyst that the shareholders have lost value over that one year period. And that might have been due to the business operations of the firm over that time period. The management decisions that Kellogg’s has taken over that time period. We will get into much more detail in the next few videos when we talk about intertemporal comparisons. For now, what that message is absolute performance, which now brings me to the next set of financial analysis tools which are comparators across firms against the competition. So rather than look at multiple periods of performance for Kellogg's, we might be interested in comparing Kellogg's recent performance against the recent performance of Kellogg's direct competitors. Or more broadly defined, the industry within Kellogg's, within which Kellogg's operates. We would label that analysis proportional or relative analysis. Another word for it is vertical analysis. Because we're using multiple line items on the balance sheet, multiple line items on the profit and loss statement to compute ratios, which we can then easily compare across other firms, competitive firms. So proportional analysis is all about relative performance rather than absolute. The ratios that we use allow us to make meaningful comparisons with those other firms. In the time series comparison, of course we can compare the value of equity in 2014 with the value of equity in 2013. Because it is the same equity for the single firm. But when we start comparing one company, Kellogg's, against a competitor, say Kraft's, then we have to take account for the fact that these corporations are not exactly identical. One might be a relatively small corporation, the other one might be much larger. To make meaningful comparisons, to avoid comparing pears and apples, we need to standardize performance metrics in a meaningful way. And we do that through a series of ratios. Not only does that neutralize any significant differences in firm size, for example, it also neutralizes the impact of the business cycle. Given that we will be comparing different firms at a particular point in time, they are all affected at the same time by that same business cycle. So in that sense, this kind of analysis neutralizes business cycle events. So does that make relative current performance a better guide than the most recent time series performance for the firm? Well, that all depends, and we will see in some detail what the preferred measure would ultimately be. So, what are good comparators? Well, we'll discuss that in some detail as well. So for Kellogg's, it might be Kraft's, it would probably be a company in the food sector, but there might be other competitors that, depending on the business decision that needs to be taken, might be more appropriate.