Importance of Financial Analysis

Financial ratio analysis is a valuable tool that allows one to assess the success, potential failure or future prospects of the company (Bazley 2012). The ratios are helpful in spotting useful trends that can indicate the warning signs of

* Return on assets (ROA) – ROA shows how successful a company is in generating profits on the amount of assets they own. Since assets consist of debt and equity, ROA is a measure of how well a company converts investment dollars into profit. The higher the percentage, the more profit a company is generating per dollar of investment. Similar to ROS, this ratio needs to be looked at compared to the industry as different industries have different requirements that can affect ROA. For example, companies in the airline and mining industries need expensive assets to operate so will have lower ROA’s compared to companies in the pharmaceutical or advertising industries.

ROA is considered the best overall indicator of the efficiency of assets used in a company. Home Depot and Lowe’s ROA ratio both moved down due to the downturn in the industry but Home Depot was able to improve 2010.

The success of a business depends on its ability to remain profitable over the long term, while being able to pay all its financial obligations and earning above average returns for its shareholders. This is made possible if the business is able to maximize on available opportunities and very efficiently and effectively use the resources it has to create maximum value for all involved stakeholders. One way the performance of a company can be measured on critical areas such as profitability, its ability to stay solvent, the amount of debt exposure and the effectiveness in resource utilization, is performing financial analysis where a set of ratios provides a snapshot of company performance and future

The first ratio that will be used is the profit margin ratio. This ratio is computed by dividing net income by sales. The second ratio to be used is known as the return on assets ratio (ROA). Return on Assets is computed by dividing net income by total assets. The final ratio that will used within this report is called the return on equity ratio (ROE). This ratio can be calculated by dividing a company’s net income by its total equity.

Ratio analysis is a very useful tool when it comes to understanding the performance of the company. It highlights the strengths and the weaknesses of the company and pinpoints to the mangers and their subordinates as to which area of the company requires their attention be it prompt or gradual. The return on shareholder’s fund gives an estimate of the amount of profit available to be shared amongst the ordinary shareholders; where as the return on capital employed measures an organization 's profitability and the productivity with which its capital is utilized. Return on total assets is a profitability ratio that measures the net income created by total assets amid a period.

ROA ratio indicates the efficiency with which management has used its available resources to generate income. In 2009 there was a decrease in ROA value, but ROA in 2010 matches the industry average. That means that assets in 2010 were used efficiently.

Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas. Financial ratios are important because they help investors make decisions to buy hold or sell securities.

It is easy to forget that pouring money into a problem will not fix it unless revenue flows continue or are increased and expenses are controlled. Some of the easiest computations can be made with information retrieved from balance sheets and income statements provided by accountants. Ratios such as the current ratio, long-term solvency ratio, contribution ratio, programs and expense ratio, general and management expense ratio, fund-raising and expense ratio, and revenue and expense ratio can provide a picture of where a company stands now compared to where it was in past years and what may need to be done in the future.

The first ratio used in the financial analysis was a profit ratio which is the Return on Total Assets (ROA).

Financial ratios are great indicators to find a firm’s performance and financial situation. Most of the ratios are able to be calculated through the use of financial statements provided by the firm itself. They show the relationship between two or more financial variables that can be used to analyze trends and to compare the firm’s financials with other companies to further come up with market values or discount rates, etc.

Measuring profitability is the most essential measure in determining the success of a company. Measuring liquidity comes from the current ratio and it is important because a company needs to be liquid to survive. Lastly, measuring efficiency is determined by accounts receivable turnover, asset turnover and inventory turnover. Measuring efficiency is significant because a company that is efficient proves that a company is managing their assets and generating money into profit. Financial ratios are important for one to understand how a company is doing and what kind of success the business is having.

The analysis will be base on the most important ratios as, Liquidity, Profitability, and Solvency Ratios.

Ratio analysis is generally used by the company to provide some information on how the company has performed during that year, so that the parties involved including shareholders, lenders, investors, government and other users could make some analysis before making any further decision towards that particular company. As mentioned by Gibson (1982a cited in British Accounting Review, 2002 pg. 290) where he believes that the use of ratio analysis is such an effective tool to evaluate the company’s finance, and to predict its future financial state. Ratios are simply divided in several categories; these are the profitability, liquidity, efficiency and gearing.

* As a percentage-return measure, ROA is comparable to cost-of-capital and market rate of return measures.