Question

Essay Question:

1. First, discuss the importance of financial analysis in strategic management. Next, discuss the three separate fronts on which an effective ratio analysis is conducted. Then, discuss the limitations of financial ratio analysis.

Thank you for your help!!

Answer 1

Importance of financial analysis in strategic management.

Executives who can turn a competitive analysis into a strategic advantage are at a premium. Most top managers recognize that one of their important responsibilities is to create value in their organizations. But they don’t always appreciate how their decisions on firm strategy are actually reflected in financial outcomes and, ultimately, market valuation.

Strategic financial analysis is a powerful, value-creating framework that helps senior executives assess strategy, analyze performance, and value a business. Executives can learn how to leverage this framework in the Strategic Financial Analysis for Business

1. Perform an in-depth competitive analysis in light of the company’s strategy
2. Evaluate current performance and its sustainability, given the strategic focus and competitive conditions
3. Analyze financial statements to assess the effective management of key success factors and business risks
4. Assess appropriateness of capital structure, given the business model and risk exposure
5. Determine if valuation multiples are reasonable, given performance expectations
6. Examine the benefits and disadvantages of corporate transactions, such as potential mergers and acquisitions, IPOs, and spin-offs
7. Value the company or business unit, given its business model and forecasted performance,

The first step in strategic financial analysis is to understand the firm’s business model, its risks and rewards, where the firm makes money, and what the challenges are. Consider questions such as: How does this firm add value? How do I understand its performance?

The second step is to assess performance. In other words, ask: How do I measure how the company is executing on a strategy? This helps measure performance and provides insights into how to improve strategy execution.

The third step is to think about the future. Consider questions such as: What factors will drive growth and profits? What tools do we use to better forecast growth and profits? Finally, apply a valuation methodology and ask: Given the forecast, what is the value of the firm?

Three separate fronts on which effective ratio analysis is conducted:

Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis.

A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements.

The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one method an investor can use to gain that understanding

Liquidity: Availability of cash over short term: ability to service short-term debt.

Ratio: A number representing a comparison between two things.

Ratio analysis: the use of quantitative techniques on values taken from an enterprise’s financial statements

Shareholder: One who owns shares of stock

Limitations on financial ratio analysis:

The most important limitations of ratio analysis include

1. Historical Information: Information used in the analysis is based on real past results that are released by the company. Therefore, ratio analysis metrics do not necessarily represent future company performance.
2. Inflationary effects: Financial statements are released periodically and, therefore, there are time differences between each release. If inflation has occurred in between periods, then real prices are not reflected in the financial statements. Thus, the numbers across different periods are not comparable until they are adjusted for inflation.
3. Changes in accounting policies: If the company has changed its accounting policies and procedures, this may significantly affect the financial reporting. In this case, the key financial metrics utilized in ratio analysis are altered and the financial results recorded after the change are not comparable to the results recorded prior to the change. It is up to the analyst to be up to date with changes to accounting policies. Changes made are generally found in the notes to financial statements section.
4. Operational changes: A company may significantly change its operational structure, anything from their supply chain strategy to the product that they are selling. When significant operational changes occur, the comparison of financial metrics before and after the operational change may lead to misleading conclusions about the company’s performance and future prospects.
5. Seasonal effects: An analyst should be aware of seasonal factors that could potentially result in limitations of ratio analysis. The inability to adjust the ratio analysis to the seasonality effects may lead to false interpretations of the results from the analysis.
6. Manipulation of financial statements: Ratio analysis is based on information that is reported by the company in their financial statements. The company’s management to report a better result than its actual performance may manipulate this information. Hence, ratio analysis may not accurately reflect the true nature of the business, as the misrepresentation of information is not detected by simple analysis. It is important that an analyst is aware of these possible manipulations and always complete extensive due diligence before reaching any conclusions.