By Suresh Menon, Principal Consultant of Six Sigma and Strategic Management | Friday, 09 April 2021, 09:13 IST

One of the most important tasks for assessing the strength of the organization within its industry is financial analysis. Managers, investors and creditors all employ some of this analysis at the beginning point for their financial decision making. Investors use financial analysis in making decisions about whether to buy or sell stock and creditors use them in deciding whether or not to lend. They provide managers with a measurement of how the company is doing in comparison with its performance in past years and with the performance of competitor’s in the industry.

Although financial analysis is useful in decision making, some weakness should be noted. Any picture that it provides the company is based on past data. Although trends may be noteworthy, this picture should not automatically be assumed to be applicable in the future. In addition, the analysis is only as good as the accounting procedures that have provided the information. When making comparisons between companies, one should keep in mind the variability of accounting procedures from firm to firm.

There are four basic groups of financial ratios: Liquidity, Leverage, Activity, and Profitability.

Typically, two common financial statements are used in financial analysis the balance sheet and the income statement.

Liquidity ratios

Liquidity ratios are used as indicators of a firm’s ability to meet short term obligations. These obligations include any current liabilities, including currently maturing long term debt. Current assets move through a normal cash cycle of inventories-sales-accounts receivable-cash. The firm uses cash to pay off or reduce its current liabilities. The best known liquidity ratio is the current ration: current assets divided by current liabilities. For the ABC company the current ratio is calculated as follows:

Current assets/ Current liabilities = $4,125,000/$2,512,500=1.64

Most analysts suggest a current ratio of 2 to 3. A large current ratio is not necessarily a good sign; it may mean that the organization is not making the most efficient use of its assets. The optimum current ratio will vary from industry to industry with the more volatile industries requiring higher ratios.

Slow moving obsolete inventories could overtake a firm’s ability to meet short term demands, the quick ratio is sometimes preferred to assess a firm’sliquidity. The quick ratio is current assets minus inventories, divided by current liabilities. The quick ratio for ABC company is calculated as follows

Current assets- Inventories/ Current Liabilities=$1,950,000/$2,512,500=0.78

                                                                                                                   = $1,618,000/$2,242,250=0.72

The ratio should be ideally near 1 so that industries operate safely.

Taking the final call I would like to say that financial analysis is one of the most important strategic management tools to assess the organizations standing against its competitors.

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