Question

Briefly describe the process of assessing the financial health of a company.

2. How should one evaluate a corporate firm's investment decisions (capital budgeting)?

1. Describe the process of assessing the financial health of a company.

2. How should one evaluate a corporate firm's investment decisions (capital budgeting)?

Answer 1

Ans 1) The financial health of a Company can be assessed by various methods. Some of the methods are as following:-

a) Ratio Analysis

The various Financial ratios related to profitabilty, debt,equity ,expenses,assets are the key factors which helps to analyse the financial health of a comapny.

The various financial ratios are key indicators in managing any type of company and are useful for analyzing market trends, for comparing the company’s performance to that of its competitors and, in some cases, for even predicting future bankruptcy.

Examples-

i) Profitability Ratio :- These ratio offer different financial performance measures of the firm in relation to the generation of profits. e.g Gross profit Ratio, Net Profit Ratio,Earning per share. Higher the ratios better the financial health of the comapny

ii) Liquidity Ratio :-These ratios help us to get the information on company's ability to comply with its financial obligations.Current Ratio, Quick Ratios,Cash Ratios. Ratios between 1.5 to 2 are considered as healthy.

iii) Asset Turnover ratio :- These ratios indicate how efficiently a company is using its assets.eg Account receivable ratio. Higher the ratio better the financial performance of the company.

iv) Financial Leverage Ratio :- These indicators give us an idea of the company’s long-term solvency. eg- Debt Ratios. 3 to 1 are considered healthy.

b) Revenue growth

The sales and other income shown in comparative profit and loss account year on year shows the sales growth of company. Increase in sales figures are good sign for healthly financial position of comapny.

c) Expenses are in line with growth of the comapny.

If the curve of expenses are getting lower or are in line with the growth of the revenue.It shows the good financial health of company.

d) If the company is able to pay all its debts on time and maintain healthy leverage of interest and tax expenses it signs towards the good healthy financial position of company.

So by assessing through the above parameters the financial heath of the comapny can be assessed well.

Ans 2) The evaluation of firm's investment decision can be made through the following methods.

a) Return on Investment :- The rate of return is expressed as percentage of earning to the investment made.Income may be taken as average annual earnings,normal earnings. Investment may be taken as initial outlay or average outlay over the life of Investment.

This method is considered as one of the better approch foe evaluating the investment. Higher the return better the investment decision.

b) Pay back period :- The time taken to cover up the cost of investment through the income earned by the investment is pay back period.

The lower the time taken the better the investment.

c) Net present value of future cash flows:- If the present value of all future cash inflows discounted with Internal Rate of Return is more than or equal to cost of Investment , then it will be considered as good investment.

d) Internal Rate of Return Method :- This method is also called time adjusted Return on Investment or Discounted Rate of Return. This method measures the rate of return which earnings are expected to yeild on Investment. Internal rate of return is defined as the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the projects.

By applying the above methods we can evaluate the corporate firm's investment decisions.