A cross-sectional analysis involves the study of an entire group within an overall population over a specified period of time. In terms of its financial application, such an analysis is usually aimed at a certain group of similar businesses or companies. This analysis attempts to determine the strongest and weakest of a certain cross-section of the business world in order to glean useful information for investments. When performing a cross-sectional analysis, an investor or portfolio manager utilizes statistical information from financial statements to assess the separate companies and make useful comparisons.
There are many different applications for cross-sectional analysis beyond the business world. For example, the United States uses the Census, which can be considered just such an analysis, as a way of studying demographic information. In terms of finance, a cross-sectional study can provide a useful overview to investors in terms of which companies to back and which to avoid.
This type of analysis differs from the sector analysis mode of investing, in which investors study how entire groupings of businesses, for example pharmaceutical stocks, are performing, with the thought that all such stocks will rise and fall in accordance with each other. A cross-sectional analysis of the pharmaceutical industry, on the other hand, would attempt to determine the best performing and most financially sound pharmaceutical companies over a specified period of time. The best of these companies, also known as the best of breed, would be the investor's focus if he or wished to buy gold-standard stocks.
Once the investor decides on the cross-section of stocks he or she wishes to study, he or she can use the comparative metrics gained from financial statements to compare certain companies to their peers. This may be done with the use of the various common size ratios that allow companies of different sizes to be compared. The investor can't simply use these numbers blindly, as certain circumstances may affect the stats of a specific business, especially in the short-term. Using these ratios—which can measure debt, efficiency, or operating capital, among other things, in conjunction with a knowledge of each company's situation—can properly distinguish the best of breed.
Anyone using cross-sectional analysis may broaden the comparison as far as he or she wants, whether to compare two companies or several. One method of making cross-sectional comparisons is to establish the best in breed as a benchmark and see how other similar companies measure up to that standard. This may allow an investor to find value in a lesser-known company. Investors using a specific ratio for cross-sectional analysis may try to come up with an average of all such ratios of companies within a cross-section, thus making it easy to distinguish which companies are underperforming and which are exceeding expectations.
