© 2000 John Petroff

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In the previous chapter, the valuation of different financial assets was shown to keep a conceptual similarity, even if each type of asset has its own unique valuation method. In this chapter we look at financial decisions for which financial analysis develops the information necessary to reach decisions. As will become apparent, the items which will need to be analyzed depend a great deal on financial strategy. Financial strategy, in turn, depends of goals, attitudes, emotions, and skills of decision makers. Again, there are similarities between strategies, as one would expect. Indeed, the various ratios and other analytical tools discussed in the third part of this manual have been devised to serve the needs of all these decision makers. Thus, when each of the ratios or other analytical tools will be discussed, we will be able to refer back to the purpose of using such ratio or tool, and this purpose is identified in this chapter.

We will look at the context of seven of the most common financial decisions:
- a supplier evaluating a company to which it sells,
- a bank lending to a company,
- leasing equipment,
- buying, selling or holding bonds,
- buying or selling shares of a company,
- acquiring a company,
- overseeing the conduct of a company by government,
- managing a company.

One of the similarities is in the procedures used. For instance, the determination of a company's ability to pay its debts with the help of a set of liquidity and coverage ratios. Often these procedures are identical regardless of purpose, but the conclusions drawn and the fields of emphasis differ. This chapter describes what each of the major types of analysts do when they study the data for a given decision. Some tools developed for one group may be used by another group, but often the intensity of its use is not the same. What this means is that all the view points are concerned with a firm's well being in so far as it affects the decision at hand, and to some extent every view point must also take a broader horizon and consider all of other points of view but not with the same intensity. For instance, a banker is primarily concerned with loan repayment, but if the borrower is to remain a good customer in the future, that borrower must continue to grow and prosper. Consequently, long term sales stability and growth cannot be neglected in evaluating a company even for a first time short term loan application.

Although similarities exist among view points, it would be dangerous to conclude that one approach can be substituted for another, or that one general approach will serve all purposes. An extreme example will illustrate this clearly. A firm may be acquired for the customers it has and not for its assets. The acquiring company may study the liquidating value of the assets which it intends to sell. Here, the analytical approach is, naturally, not one attached to the traditional concept of going concern which most lenders and owners would hold as a first requirement.

Another example is that of an analysis of new product introduction. Companies must seek sales growth to survive. Often new sales cannot be found by focusing on existing markets, but only by introducing new products, or by entering new markets. Think of fashion industries (such as clothing) or artistic production (such as movies), if one cannot innovate, it is better to close business. In this case, the approach of a financial analyst is geared to assess the ability of a firm to take on risk, in other words, to destabilize its activity, to cope with probable failures, and to deal with possible interruption of sales, production and income. This, again, is contrary to a traditional lender's desirable point of view of maintaining stability of income and regularity of payments, which lenders normally want to see in their loan applicants.

In general, much financial analysis is put in the hands of accountants. Their understanding of how numbers are prepared, seems to predispose them for this work. But, that can be an inappropriate prejudgment because accountants have a natural conservative inclination to judge firms on the basis of continuity in corporate strategy (e.g. so that accounting number are comparable over several years). As observed in the two cases of customer acquisition and aggressive sales growth used above, a strict preoccupation with a firm being the same going concern is not enough. Most analytical methods must, in fact, go well beyond the accounting numbers and study what is going on in the industry and the economy.

The following sections are organized according to type of analytical work from the most superficial and objective approach to the most extensive and internal approach. All of these analytical methods are presented here irrespective of industry consideration. Characteristics of various industries are outlined in Chapter 14, and touched upon in examples involving empirical data which are presented throughout ratios discussion. The sections of this chapter are the following:

A- Suppliers and other creditors
B- Bank lending
C- Financial leasing
D- Bond strategies
E- Options and derivatives
F- Shareholders and outside investors
G- Minority and majority shareholders
H- Merger and acquisition approach
I- Government authorities
J- Management of the company itself

See review questions Q-4.1 through Q-4.4.

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Last modified: Jun/01/01

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