Long-Term Financial Investment - Essay Example

An analysis of all the factors is necessary before buying the shares of a company. If an investor buys shares of a company whose profits have been deteriorating over the years then it is likely that the impact of the falling profits will also be reflected in the price of its shares. This will erode the value of the company’s shares and the investment will result in losses. For this reason, a careful analysis of the financial statements is a must before taking a long position in the shares of the company.

Long-term investment
The investors must make investments from a long-term point of view as this gives them the power to exercise control over their investments. An intelligent investor must not focus on the short-term movements in the market rather one should concentrate on intelligent selection (Bogle & Swensen, 2009, pp.40). Ideally, the return on a long-term investment should be 7% (Campbell et al., 2001). Stocks generally offer the best possible returns over the long term (Bodnar, 2006, pp.121).
For the period 1926 to 1998 the common stocks of large companies offered an annual return of 11.2 percent. When compared with other instruments it shows that the stocks offered a risk premium of 7.2 percent annually. Even though the returns earned on large-cap and small-cap stocks are higher as compared to other assets classes their returns are more volatile. The return on long-term bonds issued by the US government is 5.3 percent per year i.e. a real return of 2.2 percent. Though the returns on such bonds are less as compared to the stocks their returns are comparatively less volatile when compared to volatility in stock returns (Reilly & Brown, 2002, pp.92).

Financial statement analysis and its importance
The financial statements comprise of- Income Statement, Cash flow Statement and Balance Sheet. An income Statement is an estimation of the profits incurred or losses suffered by the business over a specified period of time. A cash Flow Statement is a summary of the net cash position of the business. A balance Sheet is a summarized statement of the assets owned by the business and the liabilities owed by it. Using these statements ‘Ratio analysis’ can be performed. Various types of ratios can be computed like liquidity ratio, gearing, profitability margin, solvency ratio, efficiency ratio, etc.

The liquidity ratio consists of the Current ratio that gives an idea about the liquidity position of the company. This ratio can be compared with the industry standards to analyze any deviations. It can also be compared with that of the previous years to identify any improvement or deterioration. Gearing is computed by dividing Total Debt by the Total Equity. A high gearing ratio of 4 indicates that the company is overexposed to debt. This is not a good sign as this burdens the company with fixed financial obligations that come in the way of business expansion.

It has been seen that due to the burden of servicing debt the company has to forego lucrative investment opportunities. Profitability margin like Gross-profit margin and net profit margin indicates the pricing efficiency as well as cost management by the company. A high margin indicates that the company is able to generate high revenues and is also able to maintain cost efficiency. The solvency ratio like the Interest coverage ratio is an indicator of the financial strength of the company. Like if this ratio is 1 or less than 1 it means that the earnings of the company are not sufficient to meet the interest expenses. A high-interest coverage ratio like 3 or 4 signifies that the company is capable of taking care of its interest obligations. The efficiency of company operations can be assessed using ratios like Inventory turnover ratio, debtors period, etc.
Thus financial analysis helps in measuring the profitability, financial soundness and efficiency of the activities of the business (Siddiqui & Siddiqui, 2006, pp. 617).

Price-Earning ratio
Price Earning ratio or P/E ratio is expressed as Price per share/ Earnings per share. A high P/E ratio signifies that the investors are willing to pay more for earnings generated on one share. This makes the stock more expensive than the other stocks with a low P/E ratio.

Conclusion

Financial Statements give an insight into the financial affairs of the company. The financial information that is presented in these statements must be carefully scrutinized in various ways like the computation of ratios. These ratios must be compared with that of the previous years to identify any trend. Ratios must also be compared across the industry to identify any deviations. If the profitability margin of a ‘retain chain’ says A Ltd is higher than that of its rival say B Ltd then the former must be given precedence provided other ratios of A Ltd are also favourable. Besides this, trends of the ratios like ROE and ROCE must be carefully observed before making new investments. These must be compared with other competitors of the potential investment. The one with the most favourable ratio and a strong Balance Sheet must be chosen for the purpose of making an investment.  Read More