Corporate financial managment

FINANCIAL RATIOS
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Question 1.
Discuss briefly two decisions that require the analysis of financial statements.
The financial statement of any company can be used to give a glimpse or snapshot of the assets and liabilities owned by the company and how the assets and shareholders’ funds are being put to use. Also, the financial statements indicated the cash flow position the company regarding the cash inflows, expenses, losses and how all these are being managed. Before any financial institution lends money to a firm, it is essential to analyze their financial statement to ascertain whether the loan can be recovered from the assets in case of default. Also, the financial report will give the lender information concerning the profitability and whether the firm is a going concern. Secondly, the financial statement can be used by investors before putting their monies in a specific company. An investor will invest in a firm that has more chances of maximizing their wealth, and this can be indicated in the financial statement by indicators such as profitability and return on assets.
Question 2.
Why do analysts use financial ratios rather than the absolute numbers? Give an example.
The importance of the financial ratios cannot be gainsaid. The financial ratio is the backbone of any investment decision. The use of the financial ratios enables us to make an easy comparison of the performance of companies operating in the same industry or different industries.

Ratio enables us to create a trend analysis between consecutive years of the performance of a company. For instance, return on assets will be calculated by dividing net income by the assets owned by the company. The current ratio which is used in indicating liquidity will be calculated by dividing currents assets by current liabilities. The use of absolute numbers will be misleading as some figures might suggest the company is doing well while in the real sense it is underperforming. For example, a company might experience a tremendous increase in revenue, and if the investor were to concentrate on that alone, he might lose his money as the company might be over leverage while at the same time experience a colossal increase in operating expenses.
Question 3.
Besides comparing a company’s performance to its total industry, discuss what other comparisons should be considered within the industry.
The financial ratios of a company offer information of a company relative to the industry in which it is operating. For instance, we can compare the company current ratio and return on equity with the industry average.
However, other comparisons can be used. We can consider the trends in the industry and how this is affecting the profitability of the company. An increase in new players will reduce the level of profit. A monopolistic market guarantees a more conservative investment. We should also consider the economic outlook and whether the company’s earnings can be affected massively with an adverse change in the economy.
Question 4.
When examining a firm’s financial structure, would you be concerned with the firm’s business risk? Why or why not?
It is essential as an investor to be concerned of business risk of the company you are investing in. Business risk refers to how the earning potential of a company will be affected by changes in the business environment such as tax, recession or increased competition. A business with a high business risk experience a significant shift in its earning and hence the type of capital structure it employs is fundamental. Such a firm should apply more equity and less debt for it to be operational during periods of lower earning. Business risk is necessary as it determines whether a firm will be a going concern.
Question 5.
Why is the analysis of growth potential significant to the common stockholder? Why is it important to the debt investor?
The growth potential of any company is significant. Shareholders will be attracted by a company that has the potential to increase their funds significantly. If the managers of a company prove not be able to maximize shareholders wealth, there will be a decrease in invested funds. The capital market might further punish the firm through a reduction of the share price. Debt holders will be attracted by a firm that promises to grow as they are sure that their debt will be fully paid. It is the interest of debtholders and bondholders to make sure that the interest and the principal amounts are paid on time, and they will put this money in firms that have a healthy financial position.
Question 6.
Discuss some internal company factors that would indicate a firm’s market liquidity.
Liquidity refers to the ease with which the company can sell its assets to obtain cash. Market liquidity refers to how quickly the firm can get this cash without tremendously affecting the asset price. The current ratio, quick ratio, and working capital ratio are good indicators of the ability of the firm to settle short-term debts. If these ratios are high, the firm has good market liquidity. These can further be illustrated by how quickly the company collects receivables.
Question 7.
Select one of the limitations of ratio analysis and indicate why you believe it is a significant concern.
One of the primary concern of the use of the use of financial ratios is that the information represented in the financial statement represents the actual historical data and thus might not represent the real accurate picture of the cost and the benefits generated by certain transactions.
For instance, inflation might have a significant effect on this, and thus the purchasing power of money might have reduced.
References
Brealey, Richard A., Stewart C. Myers, Franklin Allen, and Pitabas Mohanty. Principles of corporate finance. Tata McGraw-Hill Education, 2012.