Discuss the purpose and importance of financial ratios and financial analysis.
Financial Ratio Analysis is done to calculate the ratios, which would predict the financial condition of the companies. It is done by comparing the financial ratios with their competitors and rivals. Furthermore, these are also helpful in decision making for the stakeholders. It is used to attain an overall picture of the financial performance of a company.
Financial ratios are primarily used to aid the management and the investors. The investors and the management use the financial ratio analysis to determine if their firm or any other firm in which they are interested in investing is doing well on the financial basis, and on what level it is performing as compared to market benchmarks (Gibson, 2012).
Furthermore, financial ratio analysis also serves as an important tool for the understanding of the financial statement analysis. Companies, investors, analysts, and shareholders can look for trends over time, and for measurement of the financial stability of a firm. Other than this, it also aids in making comparisons across competitors within a sector, industry or within different economies (Helfert, 2004).
By getting the information-required for the financial ratio analysis, the creditors, investors, and analysts use it to predict the future performance of the companies, get an idea about their stability, and make important strategic decisions. It is also used for determination of the operational as well as the management efficiency of a firm. It gives the picture of the efficiency of a company for realizing how well it has utilized its resources and assets to earn the profit (Keown, 2002).
Moreover, it also aids the company’s management in spotting out of the weak areas and the areas, which need improvement even if the overall performance seems good enough.
What are the limitations of financial ratio analysis?
Even with all the benefits and advantages that the financial ratio analysis offers to an investor or analyst, it can be misleading as well. There are certain limitations to its implications, and the analysts need to keep these limitations in mind while making decisions. Companies often have very different organizational structures and hierarchies, which makes their overall environment quite differently. These companies are dwelling in different environments from different industries cannot have a standard comparable mechanism for predicting their financial position and financial performance. Any analysis from such different companies can be very much misleading (Khan, 2004).
Furthermore, various companies, which operate in different countries and regions, follow different operating rules, regulations and accounting policies, therefore making the clarity of their financial comparison doubtful. These numbers, which are based on different assumptions can have different meanings hence cannot be judged by the same standard.
Another major limitation of the financial ratio analysis is that it gives information about a company’s past and historical performance, whereas the investors and analysts are more concerned about the current and future performance.
Another distorting factor is inflation, which also contributes to making the results unclear got from ratio analysis. Furthermore, all the information is data based which means that if false information were presented or used, then the results would also be false, giving false information to the investors, which can be very crucial.
Another major and the usual limitation that it offers is that the numbers do not tell the whole story behind it. For example, if a company took loans on credit for its expansion, then its current ratio would be very low, and it would not say about the expansion of the company. Another aspect of its limitations is that it only tells the story in quantitative terms and therefore does not take into account the qualitative aspects of a company.
If we divided the users of financial ratios, such as short-term lenders, long-term lenders, and stockholders, which ratios would each prefer and why? Provide examples.
Short Term Lenders
The short-term lenders are interested in the ability of the firm to repay its debt in the shortest time. Therefore, therefore, they would more prefer the ratios, which calculated the short-term liquidity of the firm. As by being a liquid company, the firm can readily convert its current assets into cash and pay the interest amount payable to the short-term lenders (Riahi-Belkaoui, 1998). These ratios include:
- Quick or Acid Test Ratio
- Current Ratio
Long-Term Lenders
The Long-term lenders on opposite would be more interested in the ability of the firm to generate long-term cash flows. They are interested in the ratios, which give the information about the ability of the firm in long-term debt repayment, and its capacity to acquire the capital required to meet its business requirements. They are more interested in the solvency and leverage ratios. These include:
- Interest Earning Ratio
- Debt to Equity Ratio
- Return on Investment
- Debt to Total Assets Ratio
- Current Ratio
- Quick or Acid Test Ratio
Stockholders
Shareholders own the company. Therefore, they are more interested in the good financial health of the company. This information is given by the profitability ratios. Furthermore, they can also be interested in the advantage ratios to keep an eye on the capital acquiring sources. These ratios include:
- Earnings Per Share
- Profit Margin
- Operating Margin
- Return on Equity
- ROCE
- Return on Assets
- Return on Invested Capital
- Price/ Earnings Ratio
- Dividend Payout Ratio
- Debt to Equity Ratio
References:
Gibson, C. H. (2012). Financial Reporting and Analysis (13 ed.). Cengage Learning.
Helfert. (2004). Techniques Of Financial Analysis: A Mode (2 ed.). Tata McGraw-Hill Education.
Keown. (2002). Financial Management: Principles And Applications, (10 ed.). Pearson Education India.
Khan, M. Y. (2004). Financial Management: Text, Problems And Cases (1 ed.). Tata McGraw-Hill Education.
Riahi-Belkaoui, A. (1998). Financial Analysis and the Predictability of Important Economic Events (2 ed.). Greenwood Publishing Group,.
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