Financialanalysis is the process of assessing the performance of a business oran entity with an aim of examining their viability for investment. Itis primarily conducted to weight the profitability of the businessand any other finance- related entities. It also helps the investorsto gauge whether the entity that they are about to invest in isstable enough or solvent. When carrying out financial analysis theinvestors normally put emphasis on the evaluation of the majorfinancial statements which include the balance sheet, statement ofcomprehensive income and the cash flow statement.
Financialanalysis is categorized into two broad categories that are,quantitative analysis and qualitative analysis. Quantitative analysisis a business analysis that seeks to understand the performance usingmathematical modelling, research and measurements this is the bestway of evaluating the profitability of a business as it provides therealest techniques of evaluating the financial instruments. This,therefore involves considering those issues in the business that canbe expressed numerically such as company’s sales, assets,liabilities, the prices-earnings ratio among others. It can also beused to forecast real world circumstances such as changes in theshare price (Douglass, 2014). On the other hand, the qualitativeanalysis involves assessing the issues that are the important part ofthe business. Even though the Quantitative analysis is a powerfultool for measuring the performance of a business, it is not mostsufficient since some of the factors affecting the profitability of abusiness cannot be expressed numerically.
Sheldonshould not only consider the quantitative issues but also thequalitative issues in his evaluation of the alternative financialdecisions. This is because these qualitative factors may imposeeither negative or positive impact to the business performance. Thefactors may also add value to the business. For example, bypurchasing the ongoing business from his uncle, he is more likely tobenefit from the goodwill that the company has already created. Evenif the business is likely face challenges in near future Sheldon canstrive to make it much better which will help him outdo thecompetitors.
Quantitativeissues: Ratio analysis
Ratioanalysis is based on the elements in financial statements such as theincome statement, the balance sheet and the cash flow statement.Ratios will provide Sheldon with an early warning as it reveals thefinancial situation and performance of the company (Douglass, 2014).While assessing the financial ratios, the analyst sets acut-off-criteria on which a decision is to be based on.
Aratio is an index relating to two financial data. It is used tosummarize large quantities of financial data and can also be used forcomparison purposes. For him to determine whether to take over hisuncle’s business or start a new one downtown, the can carry out thefollowing financial ratio analysis to determine the net worth of thebusiness
Thiswill indicate to him the number of times a business can meet itscurrent obligation from its current assets (Radcliffe,2015).The recommended ratio should be 2:1. However, the higher the ratio,the better. This ratio is calculated from the following formula
Currentratio = => 1:2
Thisratio is much lower than the recommended, and therefore, thisbusiness cannot be able to meet its current obligation.
Thisis a more refined ratio which measures the ability of the firm tomeet its current liabilities out of the most liquid assets. Underthis analysis, a stock is excluded because it is relatively difficultto convert inventory into cash as compared to other current assets.Stock is also excluded because it is valued at historical cost whichmight be actually different from the actual market value of thestock. However, in this case, a quick ratio will be the same as thecurrent ratio because the firm had no stock.
Thatis Quick ratio = => 1:2
Thisevaluates the extent to which finances are used to fund businessassets. It is calculated from the formula
Debtratio = = =0.2158 =21.58%
Totalliabilities to net worth ratio
Thisratio shows how all of the firm’s debt relates to equity of theowners. The lower the ratio, the better since it indicates a higherprotection for the creditors. In the Snead’s Dry Cleaning Co., thisratio can be calculated as follows:
Totalliabilities to net worth ratio = = = 27.52%
Fixedassets to net worthratio
Thisratio shows the percentage of the assets as compared to the totalequity. It indicates how well capital is utilized to fund the fixedassets (Dun,2001).This the ratio is more than 75%, then equity is not well utilized.
Fixedassets to net worth ratio = = =120.8%
Therefore,in this company, capital is frozen to fixed assets and hence theoperating funds are not enough to support day-to-day activities ofthe business.
Theseare also called turnover ratios they indicate how effectively andefficiently a firm is utilizing assets to generate sales (Dun,2001). They include
CollectionPeriod Ratio (Days)
Thisis gotten from the formula
CollectionPeriod Ratio = Accounts Receivable ÷ Sales x 365 Days
=(5000 / 580000) x 365= 3.147 days
Assetsto Sales Ratio
Thiscompares the sales with the book value of total assets to show theeffectiveness of assets in generating sales (Dun,2001).For Snead’s Dry Cleaning Co., the asset to sales ratio can becalculated as follows
Assetto sales ratio = = = 49.14%
Otherimportant ratios that Sheldon needs to look at while evaluating theperformance of his uncles business include the profitability ratios.These ratios compare the level of to the level of sales. The higherthe ratio, the more profitable a business is (Radcliffe,2015). These are
Grossprofit margin = = =27.71%
Qualitativeissues involve the factors which may have a direct impact to theperformance of a business. Businesseshave got different terms concerning qualitative issues. Thequalitative issues which can be identified in this case of Sheldon’suncle business include customer base, competitive advantage, marketshare, business growth opportunity, regulations among others. Byanalysing these issues, Sheldon will be able to evaluate thefinancial health of this business. This will play a major role inhelping him in making his investment decision.
Purchasingan already existing business from his uncle will imply that he willinherit most if not all of the customers in the company’s database.On the other hand, if he moves down town for a new stall, Sheldonwill be at a great risk of wasting much of his time before acquiringhis permanent customers.
Thecurrent market share of the uncle’s business can be estimated withcertain. This means that, Sheldon can easily estimate theprofitability of the business in future periods unlike it is for anew business where estimates are just a mere guess. Businessgrowth opportunities
Thegreatest way of measuring the financial health of a business is byevaluating its opportunity for improvement. The best way to analysethe likelihood of business growth is by examining the growth of thepotential customers and the overall market as well. He can also growthe business operation by acquiring more capital as loans from abank. He can only qualify for a loan if he takes it with the name ofalready existing business. This implies that, purchasing his unclesbusiness, will provide more opportunities for growth.
Thisinvolves analysing the number of firms that already exist in theindustry. It is simply looking at the number firms in the industryand analysing the barriers to entry. It is obvious that stiffcompetition creates an organizational environment which is difficultto operate in (Clue, 2011). Sheldon should therefore analyse thestrengths in his uncle’s business which may help in gaining acompetitive advantage.
Sincesome ratio test are showing that the company can be profitable whileothers are showing that it is performing poorly, I would adviseSheldon to not only consider quantitative issues but also thequalitative issues while evaluating the performance of this business(Douglass, 2014). By considering qualitative issues, he will be ableto identify areas for improvement to make the business much betterthan it is. Even though Sheldon is not sure of the expansion forimprovements suggested by his uncle, I would advise him to considerthem in positive way since in investment is all about risking andthat the higher the risk, the higher the returns.Sheldon can alsoimprove the business and make it better than other competitors’. Heshould also be aware that investing in a new business is surroundedby many uncertainties since one cannot predict the performance of theparticular business.
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Douglass G. (2014). Corporate financial management 4th edition. Britain: Pearson Education.
Radcliffe, B. (2015). Ratio Analysis. Retrieved March 30, 2015, from Investopedia: http://www.investopedia.com/video/play/ratio-analysis/