4.1. Articulate the Purpose and Context of Analysis

Prior to undertaking any analysis, it is essential to understand the purpose of the analysis. An understanding of the purpose is particularly important in financial statement analysis because of the numerous available techniques and the substantial amount of data.

Some analytical tasks are well defined, in which case articulating the purpose of the analysis requires little decision making by the analyst. For example, a periodic credit review of an investment-grade debt portfolio or an equity analyst’s report on a particular company may be guided by institutional norms such that the purpose of the analysis is given. Furthermore, the format, procedures, and/or sources of information may also be given.

For other analytical tasks, articulating the purpose of the analysis requires the analyst to make decisions. The purpose of an analysis guides further decisions about the approach, the tools, the data sources, the format in which to report the results of the analysis, and the relative importance of different aspects of the analysis.

When facing a substantial amount of data, a less experienced analyst may be tempted to just start making calculations and generating financial ratios without considering what is relevant for the decision at hand. It is generally advisable to resist this temptation and thus avoid unnecessary or pointless efforts. Consider the questions: If you could have all the calculations and ratios completed instantly, what conclusion would you be able to draw? What question would you be able to answer? What decision would your answer support?

The analyst should also define the context at this stage. Who is the intended audience? What is the end product—for example, a final report explaining conclusions and recommendations? What is the time frame (i.e., when is the report due)? What resources and resource constraints are relevant to completion of the analysis? Again, the context may be predefined (i.e., standard and guided by institutional norms).

Having clarified the purpose and context of the financial statement analysis, the analyst should next compile the specific questions to be answered by the analysis. For example, if the purpose of the financial statement analysis (or, more likely, the particular stage of a larger analysis) is to compare the historical performance of three companies operating in a particular industry, specific questions would include the following: What has been the relative growth rate of the companies, and what has been the relative profitability of the companies?