Financial analysis is a process by which finance identifies the company’s financial performances by comparing the entities in the balance sheet and those in the profit and loss account (P&L). This is so because balance sheet entities are usually responsible for those to be found in the P&L i.e. assets shown in the balance sheet are responsible for sales, revenue and expenses to be found in the P&L. This analysis is important to various parties with a financial stake in the company. These include:
1. Shareholders – Actual owners are interested in the company’s both short and long term survival. For this reason they will use ratio’s such as:
a) Profitability ratios – which seek to establish viability.
b) Dividend ratios – which seek to establish return to owners in form of dividends. The common ratios include earning yield (E/Y), Dividend pay out ratio (DPO), dividend yield, Price earning ratio, all of which will measure return to owner.
2. Creditors (trade) – these are interested in the company’s ability to meet their short-term obligations as and when they fall due. For this reason they will use ratios such as:
a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid test ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against current liabilities.
3. Long term lenders – These include finances through loans, mortgages and debenture holders. These have both short and long term interest in the company and its ability to pay not only interest on debt but also principal as and when it falls due. These parties are interested in the following:
a) Liquidity ratios – used to assess short-term liability to meet current obligations.
b) Profitability ratios – used to ascertain whether the company can pay its principal back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment of interest to the lenders of the debt.
4. Directors and management of company – They will therefore be interest in:
a) Efficiency of the company in generating profits.
b) The company’s viability from the investor’s point of view and the company’s ability to generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.
5. Potential investors – these parties are interested in a company in total both on short and long term basis in particular the company’s ability to generate acceptable return on their money.
Therefore, they will use:
a) Dividend ratios
b) Return ratios
c) Gearing ratios
6. Government – The Government is interested mostly in utility companies (e.g. KPLC, KPTC) and those that will provide public services – in this case the government will be interested in their survival and thus ability to provide those services. It may be interested in taxation derived from these companies which is used for development. Government may also be interested in employment level and as such it will use those ratios that can enable it to achieve such objectives of particular importance are:
a) Profitability ratios
b) Return ratios
7. Competitors – These are interested in the company’s performance from the market share point of view and will use the ratios that enable them to ascertain company’s competitive strength e.g. profitability ratios, sales and returns ratio etc.
8. General public – Customers and potential customers – These are interested in the ability of the company to provide good services both in the short and long run. To gauge the company’s ability to provide goods and services on short and long term basis. We have: