A number of different approaches might be used in analyzing a firm. Many analysts have: favorite procedure for coming to some generalizations about the firm being analyzed. At the risk of treading on some rather sacred ground, we present a conceptual framework that lends itself to situations in which external financing is contemplated.
Taking them in order, our concern in the first case is with the trend and seasonal component of a firm's funds requirements. How much funding will be required in the future and what is the nature of these needs? Is there a seasonal component to the needs? Analytica. tools used to answer these questions include sources and uses of funds statements, statementof cash flow, and cash budgets, all of which are considered. The tools used tassess the financial condition and performance of the firm are financial ratios, a topic takeup in this chapter. The financial analyst uses these ratios much like a skilled physician uses lab -test results. In combination, and over time, these data offer valuable insight into the health of a firm - its financial condition and profitability. Completing our first set of three factors is an analysis of the business risk of the firm. Business risk relates to the risk inherent in the operations of the firm. Some companies are in highly volatile lines of business and/or may be operating close to their break-even point. Other companies are in very stable lines of business and/or find themselves operating far from their break-even point. A machine tool company might fall in the first category, whereas a profitable electric utility would probably fall in the latter. The analyst needs to estimate the degree of business risk of the firm being analyzed.
All three of these factors should be used in determining the financial needs of the firm. Moreover, they should be considered jointly. The greater the funds requirements, of course, the greater the total financing that will be necessary. The nature of the needs for funds influences the type of financing that should be used. If there is a seasonal component to the business, this component lends itself to short-term financing, bank loans in particular. The firm's level of business risk also strongly affects the type of financing that should be used. The greater the business risk, the less desirable debt financing usually becomes relative to common stock financing. In other words, equity financing is safer in that there is no contractual obligation to pay interest and principal, as there is with debt. A firm with a high degree of business risk is generally ill advised to take on considerable financial risk as well. The financial condition and performance of the firm also influence the type of financing that should be used. The greater the firm's liquidity, the stronger the overall financial condition; and the greater the profitability of the firm, the more risky the type of financing that can be incurred. That is, debt financing becomes more attractive with improvements in liquidity, financial condition, and profitability. The circled item in Figure 6.1 indicates that it is not sufficient to determine the best financing plan from the viewpoint of the firm and simply assume that it can be achieved. The plan needs to be sold to outside suppliers of capital. The firm may determine that it needs $1 million in short-term financing, but lenders may not go along with either the amount or the type of financing requested by management. In the end, the firm may have to compromise its plan to meet the realities of the marketplace. The interaction of the firm with these suppliers of capital determines the amount, terms, and price of financing. These negotiations are often not too far removed from the type of haggling one may witness in an oriental bazaar - although usually at a lower decibel level. In any event, the fact that the firm must negotiate with outside suppliers of capital serves as a feedback mechanism to the other factors. Analysis cannot be undertaken in isolation from the fact that ultimately an appeal will have to be made to suppliers of capital. Similarly, suppliers of capital must keep an open mind to a company's approach to financing, even if it is different from their own.
As we have just seen, there are a number of facets to financial analysis. Presumably, analysis will be in relation to some structural framework similar to that presented here. Otherwise, the analysis is likely to be loose and not lend itself to answering the questions for which it was intended. As we shall see, an integral part of financial analysis is the analysis of financial ratios - a topic that fills most of the remainder of this chapter.