Getting Your Return with Financial Analysis
Using the right financial analytics and techniques can mean the difference between going through with a project, for instance, or maintaining current processes. Financial analytics can aid an organization’s need to better evaluate growth opportunities and overall management performance.
Simply put, financial analysis is the assessment of an organization’s financial status. It can report on the profitability, stability and viability of performance. Glancing at an income statement is the easiest way to judge profitability – it can be done using common profit ratios like gross margin, profit margin, return on assets and efficiency ratios. However, stability and viability can be more difficult unless the right measures and metrics are in place. What’s more, advanced financial analysis can mean the difference between making sound investment decisions and making decisions based on projected costs alone.
Firm stability and viability can be judged using ratios that determine liquidity, activity and debt ratios. Each of these areas of interest can enhance the knowledge executives have about where the company is going in terms of growth and how long they can sustain themselves during slow times. These ratios beg to answer the question, ‘How long can our current financial status keep us either stable or growing?’.
Ratios any size organization can incorporate into their financial analysis include:
Current Ratio = Current Assets / Current Liabilities
*This ratio should be above 1, indicating a firm has enough resources to pay its debts for at least the next 12 months.
Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities
*This answers the question of whether or not a firm could pay off their liabilities immediately if need be
Inventory Turnover = Cost of goods sold / Average Inventory
*Determine how quickly your goods move
Debt -Equity Ratio = (Long term debt + Value of Leases) / Stockeholders’ Equity
*Finance assets by knowing the relationship between debt and Equity
How do these ratios and others lend to informed decision making about investments? Using these figures while tying them in with past performance, future performance and comparative performance (which can be determined with past financial stats and forecasting) can build upon the information a firm should have already gathered when deciding what projects to finance, whether to lease or buy and so on.
In terms of leasing, “Leasing comes with its own potential drawbacks, of course. A lease payment typically includes an interest component that a cash purchase would not include. Moreover, leasing requires the business owner to be fairly aggressive in the realm of asset management.” (Adam Stone, SmallBusinessComputing.com) That said, the results from financial analysis can show the cash that is on hand for an upfront purchase, future cash flow for interest payments and the equity needed to back up an asset should the company face hard times.
What about investing? Knowing debt and equity ratios can answer how and when to finance. Investing is a long term commitment that is dependent on long term cash flows, growth opportunities, and net present value. Present value can be the key indicator when making the investment decision. Present value is nothing more than the sum of predicted cash flows (as the result of an investment) discounted back to today. This helps determine if the price you are paying today is worth future value.
Smaller organizations may not have the capacity to compute present value for smaller purchases, but the effort is worth it when purchasing large pieces of capital or investing in campaigns or new processes. The ratios mentioned above, though, can and should be use for a firm of any size. They are easy measures that can be determined using existing information. Having a good handle on financial management takes careful financial analysis, which can lead to un-foreseen growth opportunities, cash flow troubles and revenue trends.
Watch for ASMI’s Financial Analytics Program coming in 2008!
