Question

Why is financial analysis important to

1-compare the company with the rest of its peers

2-determine the company's ability to pay its debts, borrow

3-and know the efficiency of management? Explain with examples

Answer 1

Financial analysis is important for a number of reasons:

1) Compare the company with the rest of its peers:

Relative valuation is a method whereby a firm is valued with the help of financial ratios or metrics with those of similar firms. Depending upon the purpose of valuation, a few important ratios are taken into account; such as price-earnings (P/E), price-to-sales (P/S), enterprise value / EBITDA (EV/EBITDA), then these ratios are calculated for each firm in the industry and evaluate how each firm is performing in relation to its competitors.

2) Determine the company's ability to pay its debts:

Financial analysis results in better debt management. Excessive amounts of debt can be bad for the business. Hence, the company must manage its liabilities properly.

The long-term debt-to-total-assets ratio represents the percentage of a corporation's assets financed with long-term debt, which encompasses loans or other debt obligations lasting more than one year.

This ratio provides a general measure of the long-term financial position of a company, including its ability to meet its financial obligations for outstanding loans.

An example of ABC Ltd. and XYZ Inc.is illustrated below.

In this example, we can see that ABC Ltd. reduced its LT debt ratio while XYZ increased its LTDR.

XYZ is taking on more debt for business expansion. If this strategy works, it could create shareholder value. Usually, it is better if the ratio is lower.

3) Funding/Loans:

Business loans, short-term liabilities and credit extended from vendors need to be managed. Financial reporting and analysis is important if the business needs to avail funding or loans for expansion. By examining financial statement data, the firm can determine if it needs to reduce existing liabilities before seeking funding.

Debt to equity ratio:

Banks and creditor usually look at this very important metric before advancing loans or funds to a company. Debt to equity ratio is the total debt divided by shareholder equity.  A high number may mean that a business will be unable to sustain such growth in the long term and likely to have hurdles in meeting its obligations.

An example is illustrated as follows:

ABC Ltd. has published its annual report and the following information is available.

Accounts Payable	$20,000
Current Portion of Long Term Debt	$5,000
Short Term Debt	$25,000
Long Term Debt	$60,000
Other Current Liabilities	$21,000
Common Equity	$150,000
Retained Earnings	$75,000
Preferred Equity	$100,000

The total liabilities would come to $1,31,000, after adding up accounts payable, current portion of LTD, short-term liabilities, long-term debt and other current liabilities.

Similarly, the total equity would be the sum of common equity, retained earnings and preferred equity, which is equal to $325000.

Hence, the debt to equity ratio would be calculated as:

Total liabilities/total equity = $1,31,000/$3,25,000 = 0.40

A ratio of less than 1 indicates that the share of assets provided by stockholders is greater than the portion of assets provided by creditors and a ratio of greater than 1 indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.

4) Efficiency of management:

Financial reporting and statements provide timely, centralized, and real-time insights, through which the management can make accurate, and informed decisions

Analytical reporting helps to manage the business well and also ensure compliance and good governance at the same time.