Financial statement analysis gives information that can be used to make decisions. Ratio analysis can be used to drill down into specific business measurements. Liquidity, leverage and profitability ratio are the three basic types of ratios (Johnson, 2017). The ability of a corporation to pay short-term debts is measured by liquidity ratios (LR). Current ratios are a specific example of an insightful LR. According to Johnson (2017), a company with a higher leverage ratio is better positioned to satisfy its debt commitments than one with a lower ratio. The organization may face insolvency if the CR is too low. However, there may be profit opportunities if the ratio is excessively high. As a result, LR is primarily utilized in managerial decision-making to determine a firm’s debt-paying ability and demonstrate risk lending.
Profitability ratios (PR) measure a company’s ability to generate profits and how those gains are distributed to shareholders. PR identifies which parts of company segments or processes are the most lucrative (Johnson, 2017). A specific example of PR is the gross profit margin utilized to assess the organization’s gains from its activities. PR is an excellent management decision-making tool since it assesses whether a firm produces more revenue than its expenditures. PR show how well a business generates income and value for its investors.
Leverage ratios (LR) reveal a business’s indebtedness or items acquired. While the liquidity ratio entails short-term debt, LR relates to long-term borrowing (Johnson, 2017). A specific example of LR is the debt ratio which shows a link between a firm’s liabilities and assets. Management can use LR to help guide their decision-making, particularly when comparing industry rivals and past data from the same organization. They can utilize the results of this benchmarking exercise to determine whether it is wise to invest in a given venture.
Various analytical approaches can be used by management to reach capital investment decisions. Generally, some of these include the net present value (NPV), payback method and internal rate of return (IRR). NPV is the present value of inflows minus the present value of outflows. The IRR is a discount rate that renders the NPV of all cash flows equal to zero when calculating the profitability of future investments. Finally, the payback method predicts the amount of time it will take to regain the initial expenditure.
One of the benefits of NPV is that it provides a thorough assessment of an investment’s profitability. Another advantage of NPV is that it considers both the dollar amount and the value created for the company (Woodruff, 2019). According to Woodruff (2019), NPV has many drawbacks, including the potential for future cash flow guesswork and the challenge of applying it when evaluating projects with different periods. Using NPV to evaluate an investment and how it will turn out is the gain or an example of how much value it can add to a firm.
IRR has the benefit of assisting in calculating the time value of money (TVM). Another merit of IRR is that it is simple to apply and comprehend (Lanctot, 2019). Disadvantages are that the evaluation is often performed without considering the project’s magnitude or future expenditures. Essentially, when used outside of proper contexts, it can be misread or misunderstood. An example of top advantage is that IRR encompasses future or upcoming periods when computing the TVM.
Finally, the payback method (PM) is another commonly used analytical approach. The simplicity of the PM, as well as the ability to compare multiple projects and identify the shortest period, are its advantages. However, the technique also has the disadvantage of overlooking a project’s profitability and return on investment. Essentially, it does not consider the TVM or upcoming cash flows from each expenditure after the payback period (Woodruff, 2018). The top benefit of PM is that it is an easy and quick procedure for reaching capital investment decisions.
References
Johnson, R. (2017). 3 types of ratios in accounting. Bizfluent. Web.
Lanctot, P. (2019). The advantages and disadvantages of the internal rate of return method. Small Business. Web.
Woodruff, J. (2018). Various capital budgeting methods. Small Business – Chron.com. Web.
Woodruff, J. (2019). Advantages & disadvantages of net present value in project selection. Small Business. Web.