The smooth running of an establishment is often dependent on the sort of scrutiny it is put through. The more regular and detailed the scrutiny the more is the establishment likely to profit from them and grow in terms of both customers and finances. In this article we shall take a brief look at two means of scrutinizing a business establishment (a) ratio analysis and (b) internal analysis. While neither of these scrutiny methods is, at least directly, connected to the other each of them contribute to the success of the establishment in their own way.
In the section that follows the discussion regarding these examination procedures is a case study, based again on the methods discussed which allows us to witness how a regular company puts the theoretical methods of the scrutiny methods into practical use. (Roy, 2001) Ratio Analysis One of the most widely used analysis methods Ratio analysis is often turned to by establishment owners who want to assess the exact financial strength of their company.
A range of people including investment bankers, investors of all kinds, banks etc. ave been known to turn to this particular method of analysis to gauge exactly how much their company is worth. The financial ratio of an establishment is evaluated from a single or even a large number of information collected, systematically from an establishment’s financial statements. If taken separately, in isolation financial ratio may little or nothing. However, if and when put in the right context, it is possible to provide a financial analyst with a crystal clear picture of the situation of the company and the emergent trends.
As explained a ratio becomes important simply in context to other data and criteria. For an instance let us take a look at a hypothetical situation. Say we find that the gross profit margin of a certain company is 20%, what does that mean to us? Well, nothing really. But if we put it into context and add the fact that its close competitor has a profit margin of about 10% then we understand that the company we are dealing with is quite profitable compared to its peers in the industry. (Lamb, 2004)
Ratios are of different kinds and include leverage, solvency, liquidity, profitability and operational ratios. While leverage ratio shows the extent to which debts are used in the company’s principal structure solvency ratio provides a clear picture of the establishment’s ability to produce optimum cash flow and thereby pay of its own monetary obligations. The importance of putting the ratio analysis in the right context cannot be emphasized enough. Much like computer programming ratio analysis too works according to the GIGO (short for ‘Garbage In…. Garbage Out’) law.
Given its attributes therefore using the ratio analysis in the wrong context can often be even worse than futile. This is because scrutinizing say a cyclical establishment’s profitability ratios above a less full business cycle will never provide an analyst with a precise idea of the establishment’s long-term profitability. Using any past data without making any accommodation for recent changes in the company structure (like say a merger for instance) will help predict nothing about the company’s future trends. Anand, 2006) Financial ratio analysis is usually considered to be considerably well-developed form of scrutiny.
However, this does not keep financial analysts from developing their own forms of measures for different types of industries or even specific companies. Many analysts will provide completely different conclusions based on the very same ratio analysis. Apart from the ratios discussed above analysts also identify certain other ratios such as liquidity, turnover, valuation and coverage ratios.
Internal analysis In conjunction with an external analysis an establishment must also conduct an internal analysis as a part of its SWOT process. The success and failure of a company is dependant on both on its internal as well as its external environment and neither can or should be given more significance over the other. A number of analysts are in the habit of over-emphasizing on the external environment of the company and totally ignoring the internal atmosphere of the same.
A more crucial mistake can hardly ever be made. This is because the internal atmosphere of the company often determines the very basic structure of the establishment’s set-up, in case this is faulty or lacking in some way the whole company can suffer in a major way. (Bandura, 2005) While conducting an Internal Analysis for a company analysts are known to examine the establishment’s strong points and weaknesses in various different areas. This they do through close examination of these areas through questions.