Professor B. Kariuki
August 25, 2013
Events in the world of corporate finance during the past three years have shown the importance of transparent and accurate financial reporting by businesses. There are numerous methods for evaluating the financial well-being of a business. In this paper, I will be reviewing and evaluating the financial analysis tools available to business manager, investors, and government regulators.
Compare and analyze the financial metrics and ratios used to evaluate the balance sheet and income statement information. Understanding financial statements is essential to the success of a small business. They can be used as a roadmap to steer you in the right direction and help you avoid costly breakdowns. Financial statements have a value that goes far beyond preparing tax returns or applying for loans. The balance sheet is a snapshot of your business financials. It includes assets, and liabilities and net worth. The "bottom line" of a balance sheet must always include assets = liabilities + net worth (Preparing Financial Statements, 2013). The individual elements of a balance sheet change from day to day and reflect the activities of a business. Analyzing how the balance sheet changes over time will reveal important financial information about a business. It can help you can monitor your ability to collect revenues, manage your inventory, and assess your ability to satisfy creditors and stockholders. The income statement, also known as the profit and loss statement, includes all income and expense accounts over a period of time (Preparing Financial Statements, 2013). This financial statement shows how much money the business will make after all expenses are accounted for. An income statement does not reveal hidden problems, like insufficient cash flow. Income statements are read from top to bottom and represent earnings and expenses over a period of time.
Financial ratios show the relationship of one item of a company's financial statement to another item. They are used to assess aspects of profitability, solvency and liquidity. Financial ratios for industries (or industry norms) reflect the average value for the type of business (“An Overview of Financial Ratio Analysis, 2013”). Financial ratios for companies are used by creditors and equity investors to make credit and investment decisions. Industry norms are used by people who want to compare one company's financial report with the industry averages or by people who need to identify changes in the industry's financial performance over several years.
Financial ratio analysis is one tool of investigating and comparing relationships between different pieces of financial information. You use information from the income statement and balance sheet to calculate financial ratios in order to determine information about your small business firm (“An Overview of Financial Ratio Analysis, 2013”). There is any number of ratios you could calculate. To solve that problem, there are some standard ratios that most business firms use. The problem with ratios is that they are useless unless they are compared to something. For example, if you calculate your firm's debt ratio for one time period (let's say a year) and it's 50%. All you can take from that is that, since the debt ratio is Total Liabilities/Total Assets, 50% of your firm's assets are financed by debt. You don't know if that is good or bad unless you have something to compare that 50% to.
Comparison of financial statements forms the basis for much financial analysis. Four main types of comparison are made: comparison of statements for the enterprise between successive years, comparison of a firm's statements with those of a specific competitor, comparison of a firm against an industry standard and comparison with a target, such as a company's budget (“The Uses of Financial Statements, 2013”). Comparisons between different