CLP Quick Study
Corporate Financial Management Module: Evaluating financial performance
Just recording all of the financial transactions of a business is not going to help make management decisions. The information collected must be examined and evaluated to determine what it tells you about the business.
The following list provides an overview of a process you can use to make decisions utilizing financial information.
1. Gather accurate financial information. Remember the saying “Garbage in – garbage out.” If you start with poor information you will make poor decisions.
2. Organize the information so you can see relationships. There is a lot of financial information. You want to put it together in a way that makes sense and gives you an overview of what is happening.
3. Calculate financial ratios and summarize data — a continuation of Step 2. Grouping the data allows a better understand what the underlying cause of the numbers is.
4. Look for trends or changes. The numbers alone do not mean anything; you need to compare them with something. This first comparison is to see how they are changing over time.
5. Compare your business to other businesses. Once you have looked at how the numbers are changing over time, you want to compare them to other similar business.
6. Look to see what is happening to cause these numbers. The numbers only reflect what is happening in the real world. You need to understand what is generating the numbers (good and bad).
7. Determine what steps you can take to improve, fix or maintain the results. The entire exercise is a waste of time unless you use the information to manage the business.
Ratio analysis
The next step is to look at relationships in the financial data to better understand what is happening. There are many different ratios calculated, and depending on what purposes you have, you may look at a variety of ratios (i.e. a banker may put more importance on certain ratios when evaluating the risk of granting more credit).
Four groups of ratios can be used to look at the success or financial shortcomings of a business:
Liquidity ratios: measure the viability of the business in the short term.
Profitability ratios: look more at the long-term viability of a business. Then ask the question: is the business generating an acceptable return for what has been invested?
Solvency ratios: calculate how a business’s assets are financed — by debt (lenders and suppliers) or by equity (owners).
Productivity ratios: assess a business’s operating efficiency and how effectively it uses its assets.
Although financial information and ratios provide indications of positive or negative trends, and help to identify possible problem areas, they do not always identify the actual problem. Once a negative trend has been identified, finding the problem involves a bit of detective work.
