Financial statements contain valuable information that managers can use to analyze past performance. In order to use such information, they must recognize the limitations of such data and apply techniques to overcome these weaknesses. At the same time, out of the great mass of financial information that is available, managers must sift out that which is relevant.
Financial Statement Analysis: Management can analyze financial data by (1) comparisons of two or more periods and (2) comparison within one period. The former includes the analysis of successive balance sheets and income statements to determine trends in individual items. The latter involves the analysis of current financial statements to determine the state of the firm with respect to its solvency, stability and profitability. Good financial statement analysis uses both approaches. Individual items can be compared over a period of time, with increases and decrease expressed as percentage changes.
The financial ratios illustrated have long been useful for analyzing past financial performance. Both, the greatest advantage and the greatest disadvantages of ratios come from the ease of computing ratios. With some knowledge of accounting the computation of any financial ratio is simply a matter of relating two absolute sums as a fraction â€“ simple division â€“ a major advantage. The disadvantage is that the computation is so simple that many managers carry this simplicity over into interpretation.
If the current assets consist of little cash, questionable accounts receivables, and inventories not readily marketable, a 2:1 ratio may not be high enough. Furthermore, different types of businesses require different ratios. A water company which receives payments monthly and has few liabilities that demand monthly payment may be in excellent condition with a low current ratio whereas a furniture store which requires large inventories and routinely allows several months for payment of accounts receivables may be in a tight financial condition if its current ratio is 3:1.
Recently, more differences of opinion have been voiced about the debt/equity ratio. Leverage or trading on the equity seeks to increase the rate of return to owners of equity who borrow funds at interest rates lower than the rate required for equity. This technique is even more attractive because interest payments are deductible for tax purposes. Interpretations differ regarding debt-equity ratios (leverage or trading on the equity) purely because opinions differ as to the degree of risk that is satisfactory. A conservative realizes that the debt must be paid and that bankruptcy can occur only to firms with debts while the high roller seeks to use borrowed funds whose interest is tax deductible even if the risks are high.
Cash Flow Analysis: Another very useful technique is source and application of funds analysis. This technique involves the determination of where funds have come from and how they were used, that is, a focus on cash flow. Although the term â€œfundsâ€ has a variety of meanings, in this analysis it means working capital; that is, current assets minus current liabilities. Most of the information needed for the analysis can be obtained from a comparison of two balance sheets plus some supplemental information added to reflect the flow of funds.
Source and application of funds statements accompany annual reports. They aid materially in the evaluation of managementâ€™s ability to generate funds through normal business operations and to allocate the funds to various needs. As a management tool, the statement is valuable as a basis for forecasting future sources and uses of funds; however, such analysis will normally be part of the formal budgeting process. The primary purpose of the analysis is to evaluate past performance and to raise issues regarding managementâ€™s efficiency in managing is cash flow.
These new developments are forcing top management to give special attention to financial management at a time when foreign threats are being made in operations management, especially in quality and in productivity. As a result, financial management as a scholastic endeavor cannot be separated as easily from general management and its operational and marketing functions.