One can find many definitions of financial analysis.  Investopedia defines financial analysis as “the process of evaluating businesses, projects, budgets and other finance-related entities to determine their suitability for investment.”  Wikipedia defines financial analysis as “the assessment of the viability, stability and profitability of a business, sub-business or project.  Practitioners of financial analysis may have their own definitions.  As a practitioner of financial analysis, my definition is “the process of learning about a business in order to understand what it is doing and where it is going.”

I like to emphasize the word “learning” within my definition because learning is not a perfect process.  Human beings will take steps within the process that fail to acquire the necessary insight into what a business is doing and where it is going.  The steps that lead to failure within the learning process are called biases.  Biases are real within the financial analysis.  One cannot eliminate biases but one can manage them.

The two biases that I find within financial analysis are availability and confirmation.

Availability Bias

A bias that I find within financial analysis is availability.  Availability focuses on using what comes to mind first when evaluating a situation.  One can apply availability within financial analysis when framing a situation around an explanation from someone.

I experience availability when brought into an engagement from a referral.  A person who refers me will explain a company’s situation.  The explanation can be used to understand what a business is doing and where it is going, however, the understanding is based on what comes to mind first, i.e. the perspective of the referral.  The problem is the perspective may lack insight from financial statements, perhaps the most important element of financial analysis.  So in order for me to manage bias from availability, I take the referral’s perspective as one rather than the only source of learning about a business.

Relying on what comes to mind first can hinder the ability to provide meaningful financial analysis.  Financial analysis is a learning process.  As a result, the learning process should not rely on one source; it should rely on a number of sources in order to understand what  business is doing and where it is going.

Confirmation Bias

A bias that I find within financial analysis is confirmation.  Confirmation focuses on using evidence to prove what one believes.  One can apply confirmation within financial analysis when framing a situation around a belief in how a business should operate.

I experience confirmation when comparing results, current to the prior year and actual to plan.  I reviewed a client’s income statement and saw a revenue element that declined from the prior year.  I had a belief that the client may be better with fewer product/service offerings and the revenue decrease appeared to confirm this belief.  After further review, it was determined that the revenue decrease was not due to a change in operations but a change in accounting.  Reaching this conclusion was accomplished by obtaining data in a manner that contradicted a belief.  

Obtaining information in order to provide what one believes can hinder the ability to provide meaningful financial analysis.  Financial analysis is a learning process.  As a result, the learning process should not support what you know; it should clarify what you don’t know in order to understand what is business is doing and where it is going.

Financial Analysis as a Process

My definition of financial analysis is “the process of learning about a business in order to understand what it is doing and where it is going.”  I like the word “process” because one cannot sufficiently learn about a business in one step.  One needs to learn about a business through a series of steps.

Taking steps to achieve a goal is not perfect.  Learning about a business through financial analysis is not perfect because certain missteps can occur.  Relying on what comes to mind first, availability, and obtaining information in order to prove what one believes, confirmation, are missteps in financial analysis.  These missteps (or biases), however, can be managed by obtaining data from a number of sources and challenging beliefs that one holds dear.

Remember… financial analysis is a learning process.