May types of financial analyses are used in strategic decision making these include ration analysis, break –even analysis and not present value analysis.
Financial Strategy
May types of financial analyses are used in
strategic decision making these include ration analysis, break –even analysis
and not present value analysis. Financial strategies are needed to
To raise
capital with short-term debt, long-term debt, preferred stock, or common stock.
To lease
or buy fixed assets.
To
determine an appropriate dividend payout ration.
To use LIFO (Last –in, First –out), FIFO (First-in,
First – out), or a market-value accounting approach.
To extend
the time of accounts receivable.
To establish a certain percentage discount on
accounts within a specified period of time.
To
determine the amount of cash that should be kept on hand.
1. Ratio Analysis
Ration
analysis has been accepted as an effective tool of financial analysis. The systematic use of ratios leads to interpreting
financial statements of a business enterprise. Ration is expressed in terms of
proportion or percentage relationship between two sets of phenomena. For
instance, the proportion (ratio) of gross profit to sale.
Analysis of financial ratios as a tool of strategic
analysis may be utilized in two ways: Firstly – an analyst may compare the
present ratio with the past and the expected future. For instance, the current
ratio i.e. the ratio of current assets to current liabilities – for the present
year may be compared with current ratio of the preceding year to ascertain the
level of improvement or deterioration.
This trend analysis may be the pace setter or the
eye opener for future performance of the organization. Secondly – ratios may
trend analysis may be the pace setter or the eye opener for future performance
of the organization. Secondly – ratios may also be utilized to compare the
performance of the firm with an identical firm in the same industry or the
other industry. This comparison will provide the basis of assessing the
strength and weaknesses of other competitors in the market.
Ratios may be classified under
four broad heads:
Liquidity
Activity
Profitability
Capital
structure / Leverage Ratio.
i. Liquidity Ratios
Liquidity ratios seek to confirm
the ability of the firm to fulfil its short
term obligations. If the firm has
greater liquidity than the commitments
due for payment, it means the firm has unutilized surplus which may be invested
or used in such a manner that the rate of return is optimal. The firm may also
put the funds in the expansion of business or diversification of its activities
to increase rate of return on investment.
The ratios which indicate the liquidity of the firm
are: (i) Net working capital (current assets – current liabilities) (ii)
Current ratio (current assets ÷ current liabilities (iii) Acid Test Ratio/
quick Ratio (iv) Super quick ratios (v) Turnover Ratios.
ii. Acid test ratio / quick ratio
= Current assets – (Inventories + Repayments) Current
liabilities
iii. Turnover Ratios /Activity Ratios Another way to ascertain the liquidity is how
quickly a certain current asset could be converted into cash. Ratios measuring
its ability is known as turnover ratios. These ratios may be classified under
three heads: (1) Total Assets Turnover Ratio (2) Accounts Receivable Turnover
Ratio (3) Inventory Turnover Ratio. Inventory / Turnover Ratio Inventory / Turnover Ratio may be worked out in the
following manner. Cost of goods sold (Inventory I year + Inventory II
year) ÷ 2 Profitability Ratios Profit is the end result of all business activities
including the use of capital. Profit is an objective index of judging the
efficiency of the business enterprise. Profitability ratios may be of
two kinds: Return on
sales (ROS) and Return on
Assets (ROA)
Return on Investment (ROI) is not different from
Return on Assets (ROA). In a multi- product organization, a Return on
Investment (ROI) is not different from Return on Assets (RoA). In a
multi-product organization, a lower Return on Assets indicates a weak product
or sub-optimal product or a few strong and more weaker products which lower
down ROA or even ROI. Capital Structure / Leverage
Ratios Financial solvency of the firm may be computed by
establishing relationship between borrowed funds and owner’s capital. Debt
/Equity ratio seeks to establish this relationship. “This ratio reflects the
relative claims of creditors and shareholders against the assets of the firm”.
Earnings per Share (EPS) Another way of computing the profitability of a
company from share holder’s view point is the Earnings per share. It measures
the profit available to equity holders. Profit available to equity holders are
represented by the net profits after taxes and preference divided divided by
the number of ordinary shares. Price Earning Ratio It may be worked out as follows:
2. Break – Even analysis – Case
3. Net Present Value (NPV) analysis. This method involves calculation
of the present value of estimated cash
inflows using the cost of capital as the discounting rae and subtracting from
the aggregate present value of inflows the present value of cash outflows using
the same discounting rate. IF NPV is positive or equal to zero, the investment
project is accepted as economically viable. If it is negative the proposal is
rejected. Using this, strategic investment proposals may be ranked in the
descending order of the net present values. The market value of shares may
increase with projects with positive NPVs are accepted.
Tags : Strategic Management - Functional Strategy
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