Forecasts about future business performance start with the analysis of trends in past performance. Generally, trends continue unless external
exogenous events (such as War, governmental policy decisions, major government legislation, or global events such as commodity supply disruptions, natural disasters, political and national cultural changes), and/or internal endogenous firm events (such as management changes, strategic business decision changes, product innovations, mergers and acquisitions, product line additions or deletions, or the failure to anticipate or offset vigorous competition), are accounted for or implemented and combined with other forces that cause material change. Financial analysis begins with the study of the quantitative and qualitative data reported in publications that include review of the reported financial statements, generally, the most recent quarters and the most recent three to five year period. Financial analysis includes the computations of various categories of ratios and financial measures. The historical trend in these ratios are studied and compared to industry performance and competitor performance. Forecasts and projections of those trends are then used to make predictions about future performance, usually using a selected valuation model containing underlying assumptions that are ‘best fit’ to solve the particular problem.
Ratios are useful because they standardize numbers and facilitate comparisons. They are used to assess and highlight strengths and weaknesses. In the finance literature they are classified into five major categories to answer the following questions:
Liquidity: Can we make required payments as they become due?
Asset Management: Do we have the right amount of assets for a given quantity of sales?
Debt Management: Do we have the right mix of debt and equity?
Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in the profit margins, return assets and return on the equity?
Market Value: Do investors like what they see as reflected in the Price earnings ratios and Market to Book value ratios?
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