Lesson 1, Topic 1
In Progress

5.5. Make a financial decision based on financial statements.

ryanrori January 13, 2021

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The Financial statement is the concise product of a detailed examination of a person’s financial situation that has two main purposes.

  1. Budgeting tool for clients – The process of compiling a Financial Statement is the prime vehicle through which money advisers assist clients to assess their income and expenses. They can be useful to clients as a budgeting aid.
    1. Summary of Financial Situation – As a summary of a detailed examination of the client’s financial situation, financial statements often form the basis of negotiation. For example, creditors and courts use financial statements in making decisions on proposed offers of payment.

Financial Statements aim:

  • to accurately reflect a persons financial situation
  • to provide sufficient details to enable a creditor or court to make a decision on a proposed offer of payment.
  • to convey that information in a clear and concise manner

Recommendations are made on how to improve the financial ratios of new ventures. 

Financial ratios are calculated from one or more pieces of information from a company’s financial statements. For example, the “gross margin” is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a company’s situation and the trends that are developing.

A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is meaningless by itself. If we know that this company’s competitors have profit margins of 10%, we know that it is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example, has been increasing steadily for the last few years, this would also be a favourable sign that management is implementing effective business policies and strategies.

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company’s finances and operations. An overview of some of the categories of ratios is given below.

  • Leverage Ratios that show the extent that debt is used in a company’s capital structure.
  • Liquidity Ratios that give a picture of a company’s short term financial situation or solvency.
  • Operational Ratios that use turnover measures to show how efficient a company is in its operations and use of assets.
  • Profitability Ratios that use margin analysis and show the return on sales and capital employed.
  • Solvency Ratios that give a picture of a company’s ability to generate Cash flow and pay it financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law of “Garbage In…Garbage Out!” A cross industry comparison of the leverage of stable utility companies and cyclical mining companies would be worse than useless. Examining a cyclical company’s profitability ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company’s situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the “downside” risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company’s financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.

“As in all things financial, beauty is often in the eye of the beholder. It pays to do your own work!”

The financial strengths and weaknesses of own venture are analysed in order to make suggestions to improve income and reduce costs.