Ebook The melding of financial and valuation analysis: an application
While managers frequently perform or are presented with financial ratio analysis that compares their firm's results to industry averages or other suitable benchmarks, many managers fail to grasp the significance of carrying out such an analysis and the potential benefits that may accrue from such an endeavor. The purpose of this paper is to illustrate the value of performing financial ratio analysis by melding standard financial ratio analysis with firm-valuation analysis. In this manner, not only does the significance of performing financial ratio analysis become abundantly clear, but the potential benefits accruing from various management actions can be explicitly illustrated.
As important as financial-analysis skills are to investors and creditors, these skills are even more important to general managers who in the aggregate decide how society's limited resources are allocated within the economy. The former perform their analyses from the outside looking in and are passive observers with respect to a firm's operations. The latter, on the other hand, are active participants in the firm's operations. It is their choice of actions and their effectiveness in carrying out those decisions that determine not only the value of the firm to the shareholders, but also the efficiency with which the nation's limited capital resources are employed. Th us, regardless of the general manager's functional specialty or the size of the general manager's company, general managers need to possess financial-analysis skills so as to be able to diagnose their firm's ills, prescribe useful remedies, and anticipate fully the financial consequences and benefits of their actions.
Unfortunately, many general managers do not fully understand accounting and finance and, thus, are working under a handicap. "You can't manage what you can't measure." And, you cannot evaluate alternative courses of action if you are unable to assess fully the consequences and benefits of these actions. Financial ratio analysis is more than simply a printout of a listing of financial ratios. Financial ratio analysis need to go further by indicating the potential changes in a firm's cash flows from undertaking policies to remedy unfavorable financial ratios. To any other than the finance professional, the total significance of this action and the resulting change in cash flows is often missed or misunderstood.
Sadly, many general managers fail to grasp the significance of doing such an analysis and the potential benefits that may accrue from undertaking such an endeavor. Seldom do they look beyond the immediate numbers to see the potential resulting impact on the firm's cash flows by instituting differing operating and financing strategies. Yet, by tracing financial ratio analysis from company performance evaluation, through potential corrective actions to cash-flow impacts, and ultimately firm value, general managers will be better able to appreciate the significance of financial analysis and how their managerial actions and decisions can impact the value of the firm. Thus, by melding standard financial ratio analysis with firm-valuation analysis, the general manager can better understand and determine how much of the firm's value depends on his or her actions, and how much impact on firm value will result from instituting differing managerial alternatives. It is important that the executives responsible for operations realize how much impact they have on the firm's value and more specifically on what that value depends. The purpose of this paper is to explicitly show how changes in cash flows from operating and financing decisions made as a result of financial ratio analysis can impact the value of the firm by applying firm-valuation analysis to the resulting cash flows.
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