Financial Analysis Tools and Techniques

Updated for the 2026-2027 CFA® Level I curriculum.

Financial statement analysis only works if you apply the right tool to the right question. This note covers the framework analysts use to structure that work, the core tools available, and where each one breaks down. Level I tests this mostly through short scenario questions that ask you to identify the correct tool or spot its limitation, not through heavy calculation.

Key Takeaways

• The financial analysis process has six steps, from stating the purpose to following up later.

• Ratio analysis, common-size analysis, graphical analysis, and regression are the main tools tested at Level I.

• Common-size analysis restates statements as percentages, which supports comparisons across companies of different sizes.

• Ratios and common-size figures are only comparable across firms if the underlying accounting methods are consistent.

• Every tool has a stated limitation: ratios need a benchmark, common-size hides absolute scale, and regression assumes past relationships hold.

• This note covers the general toolset and process, not the specific ratio formulas taught in later notes.

What You Need to Know for CFA Level I

• The LOS asks you to describe tools and techniques, including their uses and limitations. You will not be asked to derive every ratio formula here.

• Know the six-step financial analysis process well enough to place a described analyst activity into the correct step.

• Recognize common-size statements (vertical and horizontal) as a tool distinct from ratio analysis.

• Understand why analysts adjust reported figures before comparing companies, especially for inventory, depreciation, and lease differences.

• Keep this note separate from the specific ratio categories (activity, liquidity, solvency, profitability), which have their own note.

• The main trap is treating a single ratio or percentage as a complete conclusion without a benchmark or comparability check.

Match the Tool to the Analytical Question

Start with the decision the analysis must support, then choose tools that organize, compare, or interpret the relevant information. The Financial Statement Analysis Framework explains the full process; this note focuses on the tools used within it.

Core Analytical Tools

Ratio Analysis

A ratio expresses one financial statement item relative to another. Ratios compress large statements into comparable figures, which supports trend analysis (one company over time) and cross-sectional analysis (one company against peers or an industry).

Ratio analysis is fast and standardized, but a ratio alone has no meaning. It needs a benchmark: a prior period, a competitor, or an industry average.

Common-Size Analysis

Common-size statements restate financial statement items as percentages instead of absolute currency amounts.

• Vertical common-size: Each income statement item is divided by total revenue. Each balance sheet item is divided by total assets.

• Horizontal common-size: Each line item is indexed to a base-year value, showing growth or decline over time.

Common-size statements let you compare a small company and a large competitor directly, since both are scaled to 100%.

Graphs and Regression

Graphs display trends and relationships visually, which helps when a pattern is easier to see than to calculate. Regression analysis estimates the statistical relationship between two or more variables, such as how revenue responds to a change in advertising spend. Regression estimates historical statistical relationships. When using it for forecasts, assess whether the relationship and model assumptions remain appropriate; association alone does not establish causation.

Making Statements Comparable

Tools only work on comparable inputs. Two companies can report very different numbers for the same economic event because of different accounting choices. Common issues tested at Level I include:

Before comparing two companies' ratios, check whether these differences exist and adjust the data if the difference is material to the question being asked.

Uses and Limitations of the Tools

Working Example

An analyst compares two retailers, Company A and Company B, for the same fiscal year.

Company B uses FIFO inventory costing. Company A uses weighted average costing. Prices have been rising all year.

Step 1: Build vertical common-size gross margins.

Step 2: Check comparability before concluding the margins are equal.

Rising prices mean FIFO assigns older, lower costs to cost of goods sold, which inflates Company B's reported gross margin relative to a weighted average method during inflation. Company A's weighted average method blends older and newer costs, producing a more moderate margin.

The two companies show an identical 30% common-size gross margin, but the comparison is not clean. Part of Company B's result is an accounting effect from its inventory method, not necessarily a true operating advantage. The analyst should adjust Company B's cost of goods sold to an equivalent basis before concluding the two companies perform equally well.

Use Horizontal and Vertical Analysis to Answer Different Questions

Suppose a company's revenue rises from $100 million to $120 million, while COGS rises from $60 million to $78 million. Set each line's base-year value to an index of 100.

The indexed figures show COGS growing faster: 30% versus 20%. Vertical common-size analysis answers a related question by showing COGS rising from 60% to 65% of revenue. One tool displays growth relative to each line's own starting value; the other displays the cost structure relative to sales.

Neither index means COGS equals 130% of revenue. Mixing these bases would reverse the interpretation.

Keep the absolute amounts available alongside the percentages. Indexed growth can look dramatic when a starting amount is very small, and a zero base makes the ordinary index undefined. For a graph, preserve a clear scale and comparable periods so the display supports the same interpretation as the underlying figures.

Common Exam Traps

Treating a ratio as a stand-alone conclusion

A ratio only means something next to a benchmark. A 30% gross margin is not "good" or "bad" without a peer or trend comparison.

Confusing common-size analysis with ratio analysis

Common-size statements restate the full statement as percentages. Ratios compare two specific line items. The exam may describe one and ask you to name it.

Ignoring accounting method differences before comparing companies

Comparing even common-size numbers across firms that use different inventory, depreciation, or lease methods can create a false sense of comparability.

Assuming regression relationships are permanent

A historical statistical relationship between two variables can break down if the business or economic environment changes.

Mixing up vertical and horizontal common-size analysis

Vertical analysis uses a base figure within the same period (revenue or total assets). Horizontal analysis uses a base year across time. Candidates sometimes swap these definitions under time pressure.

Practice Question

An analyst is comparing the income statements of two chemical companies of very different sizes. The analyst wants a technique that restates each company's income statement as a percentage of revenue, allowing a direct size-adjusted comparison for the same fiscal year. Which technique is most appropriate?

1. Regression analysis

2. Vertical common-size analysis

3. Horizontal common-size analysis

FAQs About Financial Analysis Tools and Techniques