Financial statement analysis focuses primarily on isolating information that is useful for making a particular decision for both internal and external users. Internal investors, such as executives or managers, may perform this process to make internal decisions such as capital budgeting. External users, such as creditors or investors, may use this process to take decisions such as offering credit or investing in your business.
Respond to the following in a minimum of 175 words:
List 3 ratios used for analysis and describe how each can be used in decision-making by internal or external users.
Are financial ratios enough to make internal or external decisions related to a company? State why.
Reply to these two classmates statements below whether you agree or disagree. State why and explain. or your faculty member. Be constructive and professional. You will respond in 100 words each statement.
1)Financial ratios are an important instrument in financial statement examination. Financial ratios are mathematical computations that shed light on many aspects of a companys financial performance and situation.
Three typically utilized ratios in financial statement analysis are:
1. Current Ratio: To determine the current ratio, divide current assets by current liabilities. This ratio measures a companys capacity to satisfy its short-term obligations using current assets (Fernando, 2024). Internal users can use the current ratio to monitor the companys liquidity and short-term financial health, which can assist them make decisions about working capital management or short-term financing. External users, such as creditors, may use the current ratio to assess a companys ability to repay short-term loans, which may influence their choice to issue credit to the company.
2. Return on Investment (ROI): The ROI ratio calculates a companys profitability in relation to its asset investments (Fernando, 2023). It is computed by dividing net income by total assets. Internal users might utilize ROI to assess the efficacy of investments and make decisions about capital allocation or strategic planning. External users, such as investors, may use the ROI ratio to evaluate the companys profitability and investment prospects, affecting their decision to invest in it.
3. Debt-to-Equity Ratio: This metric compares a companys overall debt to its shareholders equity (Fernando, 2024). It represents a companys financial leverage and risk exposure. Internal users can utilize the debt-to-equity ratio to evaluate the companys financial leverage and make decisions on debt financing or capital structure optimization. External users, such as creditors or potential investors, may use this ratio to assess the companys solvency and financial stability, affecting their decision to lend or invest in the company.
Although financial ratios provide useful insights into a firms financial performance and situation, they may not be adequate on their own to make internal or external judgments about the organization. To make educated decisions, financial statement analysis should be supplemented with a thorough examination of qualitative elements, industry trends, market conditions, and other non-financial data. Furthermore, financial ratios should be understood in light of the companys unique conditions and goals to ensure informed decision-making. As a result, while financial ratios are important tools in financial statement analysis, they should be utilized in conjunction with other information to make informed internal and external judgments about a company.
Fernando, J. (2023, December 22). Return on Investment (ROI): How to Calculate It and What It Means. Investopedia; Investopedia. https://www.investopedia.com/terms/r/returnoninves
Fernando, J. (2024, February 20). Current ratio explained with formula and examples. Investopedia. https://www.investopedia.com/terms/c/currentratio
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Fernando, J. (2024, March 6). Debt-to-Equity (D/E) Ratio. Investopedia. https://www.investopedia.com/terms/d/debtequityratio.asp#:~:text=%2FE)%20Ratio%3F-
2)Financial ratios are essential tools used by both internal and external users to evaluate a companys performance and make informed decisions. Three key ratios commonly used in analysis are:
Current Ratio: This ratio measures a companys ability to pay short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities. A higher current ratio indicates better liquidity, which is crucial for internal users such as management to ensure the company can meet its short-term obligations. External users, like creditors and investors, also rely on this ratio to assess the companys financial health and its ability to honor debt commitments.
Return on Equity (ROE): ROE measures a companys profitability relative to shareholders equity, calculated by dividing net income by shareholders equity. It provides insights into how effectively management is using equity financing to generate profits. Internal users, including management and employees, use ROE to evaluate performance and devise strategies to enhance profitability. External users, such as investors, use this ratio to compare profitability with other companies and make investment decisions.
Debt to Equity Ratio: This ratio compares a companys total debt to its shareholders equity, indicating the proportion of financing that comes from creditors versus shareholders. It is crucial for assessing financial leverage and risk. Internal users, particularly financial managers, use this ratio to balance debt and equity financing to optimize the capital structure. External users, such as investors and analysts, use it to evaluate the financial stability and risk profile of a company before making investment decisions.
While financial ratios are powerful tools for analysis, they are not sufficient on their own for making comprehensive decisions. Ratios provide quantitative insights but do not capture qualitative factors such as market conditions, competitive landscape, and management capabilities. Moreover, ratios are based on historical financial data, which may not always predict future performance. Therefore, it is essential to complement ratio analysis with other qualitative assessments and forward-looking information to make well-rounded decisions.
References:
Books:
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengage Learning.
Penman, S. H. (2012). Financial Statement Analysis and Security Valuation. McGraw-Hill Education.
White, G. I., Sondhi, A. C., & Fried, D. (2003). The Analysis and Use of Financial Statements. Wiley.
Articles and Papers:
Beaver, W. H. (1966). Financial Ratios as Predictors of Failure. Journal of Accounting Research, 4, 71-111.
Altman, E. I. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy. The Journal of Finance, 23(4), 589-609.
Websites:
Investopedia: Financial Ratios
Corporate Finance Institute (CFI): Financial Ratios
Financial Management Service (FMS): Understanding Financial Ratios
These references provide comprehensive insights into financial ratio analysis and its application in decision-making for both internal and external users.
