3.1 Who needs ratios? The external stakeholders’ perspective

Profitability: Although all external stakeholders are interested in an assessment of a company’s performance in terms of profitability, creditors and investors will have a special interest due to their money being invested in the business. An analysis of profitability provides an indication of whether investors will be able to earn sufficient return on their investment, creditors will be able to recover their lending and whether the level of risk and return on this investment is akin to making such an investment elsewhere. If at the given level of risk these providers of finance expect to gain better returns on their investment elsewhere, then they will potentially move their funds to an alternative investment.

Liquidity: An analysis of financial statements indicates whether the company will be able to honour its debts and financial obligations. This will involve an assessment of whether the company has timely access to sufficient amounts of cash when payments for interest and principal become due. The assessment will include an evaluation of the levels of working capital and whether there is sufficient cash to meet financial obligations when they fall due. A company’s suppliers and lenders will be particularly interested in this information.

Financial leverage: External stakeholders, more specifically investors and lenders, are interested in knowing who controls the company and who are the major suppliers of finance. It includes an assessment of the capital structure of the company and involves reflection on the level of risk inherent in the business. Users will assess who owns the company, who controls it and who influences future corporate strategy.

Efficiency: External stakeholders, specifically investors and suppliers, may need to make an assessment about how efficiently a business uses its resources, such as credit facilities or assets. Investors will be interested in assessing the operational effectiveness and performance of corporate management. Suppliers will be interested in evaluating the company’s ability to pay its bills when they become due and to manage inventory effectively, as these factors have a direct bearing on the company’s relationships with its suppliers.

Investors: Investors might be interested to know if the business can generate sufficient funds to pay dividends at a required rate. These ratios help them evaluate the success or failure of a particular investment.

External stakeholders may also want to assess cross-sectional and longitudinal analysis of financial statements for the purposes of examining its performance over time and across the industry or market.