Financial analysis (FA) in financial management entails evaluating a companys financial position to come up with ways of managing risks associated with its core business activities. By going through data on performance, a business organization obtains information which can be utilized in evaluating the viability of projects and also the profitability and stability of the business as a whole (Peterson & Fabozzi, 2006). In other words, FA helps firms to gauge risks and returns of investments and measure them against the interests of employees, customers, debtors, and shareholders, among other stakeholders (Ravinder & Anitha, 2013). Most usually, the exercise involves examination of the balance sheet, and income and cash flow statements over a given period.
Financial analysis further involves assessment of a companys historical data for the decision making about the daily running of the company. Historical facts, recorded in monetary terms, are evaluated against a given year in order to assist in revealing the journey the company has travelled since inception, its current position in the market, and future prospects (Ravinder & Anitha, 2013).Information obtained in this manner is crucial for leaders to make sound decisions that will not only see the company realize its vision but also allow such organization to deliver quality goods and services to the customers, among other societal obligations.
Financial analysis is critical in many ways. First, the practice helps business leaders to measure the solvency of their respective firms (Ravinder & Anitha, 2013).According to Ravinder and Anitha (2013), an insolvent firm holds the ability to honor its debt obligations without compromising the daily activities of the organization. Given this, financial analysis helps managers and business leaders to design policies that aim at strengthening the ability of businesses to repay loans both in the short-term and in the long run(Maynard, 2017; Ravinder & Anitha, 2013). By so doing, such leaders put their firms in a strong position of fulfilling their vision.
Financial analysis is also significant in the sense that it helps managers to assess the operational efficiency of an organization. For instance, the process can identify areas of weakness that may require remedial actions through financial injection or lean management of financial resources. By the same stroke, it helps managers to select projects that can deliver the maximum possible returns for the organization. Such insights reduce wastage and also identify the possible investments that are likely to lead to loss of funds (Ravinder & Anitha, 2013).
One of the most tools of financial analysis is ratio analysis. A ratio has been described by Peterson and Fabozzi (2006) as a mathematical relationship between two distinctive quantities. Nuhu (2014) explains that ratio analysis is the process of relating two or more elements of financial statements to make sense out of the relationship in so far as the financial position of a given institution is concerned. Essentially, it compares one item to another, and the result is related to historical data in regards to similar relationships to arrive at observations and conclusions on the financial performance of the firm over a particular period. Evidently, the two financial statement items must have a relationship for comparison to yield financial meaning. For instance, credit sales and receivables are related, and a ratio expressed as one of the other will have some financial sense, but a ratio expressed as costs to non-current assets will not make any financial sense(Maynard, 2017 p.196).
Ratio Analysis and Stakeholders
Information obtained from ratio analysis can be only used not only by employees and managers but also offer insights to external stakeholders such as customers, debtors and shareholders (Maynard, 2017; Nuhu, 2014) on various managerial issues of an organization. Each stakeholder develops interest in given ratios depending on how such interpretations affect their interests in the firm in question. For example, the current ratio may turn out to be more relevant to managers than shareholders whereas shareholders may express more interest in return on investment than the current ratio.
Short-term lenders to businesses advance their monies with the expectation that it will be paid within the shortest time possible mostly within one year (Mill& McCarthy, 2014). This means their focus as stakeholders in the business is more likely to concentrate on the ability of the firm to honor its short-term obligations. For this reason, awareness of liquidity and profitability ratios can offer insights into the safety of their money in the hands of creditors. For example, liquidity ratios will help short-term lenders to evaluate the ability of the firm to owner its short-term liabilities while profitability ratios assist the lenders in assessing the company's ability to manage its expenses (Peterson and Fabozzi, 2006).These functions are critical as they help lenders to evaluate the riskiness of companies before they advance short-term credit.
Long-term lenders are those that advance credit to a financial institution for more than one year. These types of lenders are often paid regular fixed amounts as the interest for the money they have advanced to business organizations (Nuhu, 2014). Bondholders and debenture holders are examples of these groups. Profitability ratios can be an important source of information for long term lenders as it offers information on the ability of a borrowing company to meet its annual interest obligations (Maynard, 2017).Often, interest obligations are met by yearly profits. Besides, financial leverage ratios may also be helpful to long-term lenders as they offer insight into the borrowing companys capital structure (Peterson and Fabozzi, 2006).This way, they can gauge whether the company operates on heavy debt which may endanger the long term interests of lenders, or optimizes its leverage as a strategy to maintain a stable financial structure.
Stockholders are owners of capital in a business organization. These are the investors who expect managers to prudently manage their funds in a way that yields dividends on an annual basis as well as in a manner that protects the long term future of their funds (Nuhu, 2014). Due to the nature of their interests, profitability ratios and return on investment ratios can be important tools for protecting their money. For instance, better profitability ratios give a positive picture of the potential of shareholders to receive dividends at the end of each year. By the same stroke, solid returns on investment ratios offer an optimistic assessment of the long term interests of shareholders. This assures the investors in so far as the sustainability of the business is concerned (Peterson and Fabozzi, 2006).
Financial analysis enables managers to assess the financial position of an organization, evaluate projects as well as draw budgets that help to create the future of any organization. Stakeholders such as stockholders, long-term lenders, and short-term lenders can also benefit from ratio analysis as it helps them to monitor the business activities of the borrowing firms, thereby keeping them in check in so far as protecting their money is concerned. However, it should be noted that ratio analysis has some weaknesses that need to be addressed by looking at other factors that impact organizational performance. As such, they should not be considered as an end in themselves.
Maynard, J. E. (2017). Financial accounting , reporting, and analysis. S.l.: Oxford University Press.
Mills, K., & McCarthy, B. (2014). The state of small business lending: credit access during the recovery and how technology may change the game. Harvard Business School.
Nuhu, M. (2014). Role of ratio analysis in business decisions: a case study on NBC Maiduguri plant. Journal of Educational and Social Research, 4(5), 105-118.
Peterson, D. P., & Fabozzi, F. J. (2006). Analysis of financial statements. Hoboken (N.J.: John Wiley and Sons.
Ravinder, D., & Anitha, M. (2013). Financial analysis A study. IOSR Journal of Economics and Finance, 2(3), 10-22. doi:10.9790/5933-0231022
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