Purpose and importance of financial analysis
What is the purpose and importance of financial analysis? What are financial ratios? Describe the “five-question approach” to using financial ratios. What are the limitations of financial ratio analysis? If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?
Financial Ratios in particular is a tool that “gives us two ways of making meaningful comparisons of a firm’s financial data” (Keown, Martin, & Petty, 2014). They first off, examine ratios across certain times as well as compare firms with other firms that may be in the same industry. With this information, you can determine things like risk of investing in a company, their performance vs. other similar companies and vs. the index, as well as what size their company is, which ultimately helps people like me, Contracting Officers, award based on business size if the company is a large or small business. Financial Ratios has what they call the five question approach. This five question approach is as follows; “1. How liquid is a firm? 2. Are the firm’s managers generating adequate operating profits from the company’s assets? 3. How is the firm financing its assets? 4. Are the firm’s managers providing a good return on the capital provided by the shareholders? 5. Are the firm’s managers creating shareholder value?” (Keown, Martin, & Petty, 2014). These five questions in short will help one map out the process of using financial ratios. With these five questions you can almost find out everything you need to know about an organization financially. Even though financial ratio analysis is an amazing tool, it, like everything else has its limitations. An abbreviated list follows; “1. Because companies can operate in multiple capacities, making their money from several different revenue streams in several different areas of business, it is sometimes hard to categorize a company to a specific industry. 2. Industry averages that are published are only approximate values, not actuals. 3. Industry averages are not always considered desirable targets. 4. Accounting practices are not standard among all companies. 5. Financial ratios can be inaccurate. 6. Many firms have variance in their peak seasons of business. While these weaknesses need to be taken into account, financial ratios are still a very useful tool” (Ratio Analysis). As far as ratio users go, between short term, long term lenders and stockholder, all of them first of all are out to make money. I think whichever party has the most money invested into the company would be the party to which it is most important. I feel it is vitally important to short term lenders because you want to make sure the company is profitable enough to pay you back in the planned payment schedule. I believe it is important to long term lenders as they want to make sure the company is healthy enough to survive to make long term payments. Lastly, with the stockholders, it is important to them, because they want to make a solid investment over the long term, while maximizing profitability in the short and long term.