Fundamentals of Business

Financial analysis

Assessment of the (1) effectiveness with which funds (investment and debt) are employed in an enterprise, (2) efficiency and profitability of its operations, and (3) value and safety of debtors claims against the firm's assets. It employs techniques such as 'funds flow analysis' and financial ratios to understand the problems and opportunities inherent in an investment or financing decision.

Financial analysis aims to help in controlling the effici efficiency ency and effectiveness of the enterprise

Use the financial documents to analyse an enterprise financial performance.

The following are important ratios

There are five main measures which help to guide the analysis of liquidity or solvency, The ability to pay for liabilities when the fall due:
Current (working capital ratio) ratio = Current assets/Current liabilities Acid test (quick ratio) = quick assets/ current liabilities

Quick assets are defined as current assets less stock.

The ratio gives a more immediate measure assuming the worst possible scenario, that none of the stock can be sold sold. It is a measure of solvency - the ability of an enterprise to pay for its liabilities when they are due due.

The size of the current ratio is determined by the interrelation of two factors:
I. Cash conversion cycle - the shorter the period, the lower the ratio
II. Frequency of purchase (Replacement rate) - the greater the frequency, the lower the ratio.

Inventory turnover ratio = cost of sales/average stock
The ratio measures the speed with which stock is turned over. It provides information on the efficiency of stock management and can indicate whether capital is locked up in unnecessarily large volumes of stock.

Debt Debtors to sales ratio ors = Debtors/Sales x 100

In most commercial and industrial organisations, goods are supplied on credit (default 30 days) The sales figure in this ratio must be strictly credit sales, for the relationship to be meaningful. The lower the percentage the more efficient the management of debt collection collection. It is more useful to show this ratio in terms of months and days rather than as a percentage:

Debtors/Sales x 12 = Average collection period in months
OR
Debtors/Sales x 365 = Average collection period in days