Theory of Financial Analysis

Financial statements are designed to be analyzed. Analyzing financial statements should not be a guessing game; rather, clarity is better. The threat of inaccuracy should be minimized. A document is a "costume" which a financial statement wears. But don't be fooled by the appearance; just beneath the surface is a rigorously designed logical substrate.

I pose a hypothesis and I have reached a conclusion that my hypothesis was correct and I now have my Theory of Financial Analysis. Here is some of the empirical evidence that has led me to believe that there are patterns within financial analysis and those patterns can be explained by a theory.

Financial modeling is an approach to financial analysis. Financial modeling is a tool to understand financial information for one or more economic entities and to perform analysis and to guide decision-making. There are patterns of financial modeling and financial analysis.  Here are some of the common financial analysis patterns:

  • Three Statement Model: The three statement model projects operating and financial  performance of a particular economic entity using historical information, relevant industry information, and information gleaned from company management. Historical and forecasted financial statement information includes an income statement, balance sheet, and cash flow statement.
  • Period Comparison: Period analysis which compares information related to one economic entity across many periods. Such an analysis could be created based on "as reported" information or "normalized" information. (Example)
  • Entity Comparison: Peer analysis which compares information related to multiple economic entities as of a specific point in time and/or over a specific period of time. (Example)
  • Variance Analysis: Analyzing why something changed.
  • Common Size Financial Statements: Financial statements shown as percentages of totals.
  • Normalized Financial Statements: Financial statement comparison using a normalized model.
  • DuPont Analysis: DuPont analysis is a technique for computing return on equity (ROE). It helps compare the strengths and weaknesses of companies and operational efficiency.
  • Discounted Cash Flow Model: One approach to determining the value of an economic entity is to use discounted future cash flows.  You can determine discounted future cash flows by creating a discounted cash flows model (DCFM).
  • Merger Model: A merger model (accretion/dilution analysis) is one of the core tools in M&A financial modeling. A merger model evaluates how a proposed acquisition will affect the acquirer’s earnings per share (EPS) after the deal closes. In other words, it answers the question, “Will this deal make our EPS go up (accretive) or go down (dilutive)?”
  • Leveraged Buyout Model: A leveraged buyout (LBO) model is used by private equity firms that engage in leveraged buyouts which are acquisitions of companies where a substantial percentage of the purchase price is funded using debt. The LBO model determines the “floor valuation” or maximum purchase price which a private equity firm can offer to acquire the target yet still meet its minimum return hurdle.
  • Comparable Company Analysis: The comparable company analysis (a.k.a. trading comps model) is a form of relative valuation where the value of a target company is estimated by analyzing the valuation of comparable companies or industry peers.
  • Precedent Transactions Model:  The precedent transactions model (a.k.a. transaction comps) is similar to the comparable company analysis in that it uses other M&A transactions that have taken place to estimate the value of a target company.
  • Restructuring Model:  The restructuring model estimates the value of a company on a “going concern” basis post-reorganization and then compares the valuation to the implied value of the liquidated assets belonging to the company. A 13-week cash flow model is prepared under cash-based accounting instead of accrual accounting to measure the near-term performance of a distressed company to quantify its short-term liquidity needs.
  • Capital Investment Model:  A capital investment model is used as part of a capital budgeting analysis where metrics such as the net present value (NPV), internal rate of return (IRR), and payback period are computed to decide whether to proceed with a project or not. Capital investment models are most often used internally by economic entities to determine if a project is worth pursuing from an economic perspective and to guide their long-term strategic plans to achieve growth and scale. 
  • Lender Credit Model: Credit models are used by lenders to perform credit risk analysis on a specific borrower and request for debt capital. The credit model will estimate the debt capacity of the borrower, gauge the risk of default, and determine the appropriate amount of debt to offer (i.e. debt sizing) based on the borrower’s risk profile.
This is only a few very common model patterns of the many, many model patterns. Models should be connected to the underlying information driving the models.


In simple terms, the Theory of Financial Analysis states that there are patterns related to financial analysis and those patterns can be leveraged.  One specific pattern is that of the financial models used in financial analysis.

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