Discuss the purpose and importance of financial ratios and financial analysis. What are the limitations of financial ratio analysis? 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.
Solution
Financial ratios are the relationship which is determined by using measures on the financial information of the company for the aim of comparing. The examples of the ratios include the return on investment, the return on equity and the return on assets. The ratios are the result of dividing or multiplying one account with another financial account or measurement. The required financial information is usually found in the financial statements of the company, i.e., income statement, the cash flow statement, the statement of changes in equity and the balance sheet. The financial ratios are utilized to provide the business owners, investors, and managers with a valuable tool which can be used to measure the progress of the company as compared to the predetermined goals, competitor’s performance, analysis of the business analysts, or pre-identified trends. The use of financial ratios can aid in the industry comparison, a comparison with benchmarks, or for the identification of trends of the financial accounts in their early stages (Fridson and Alvarez).
The financial ratios are calculated with the aim of determining the financial condition of the company. The results of the financial ratios can be used for the comparison between the contemporaries. These ratios provide the holistic picture of the financial position of a company regarding its profitability, liquidity, solvency and debt position. The financial ratio analysis can be used by the analysts and by the company management to assess what benchmarks have been attained, how well the resources of the company have been utilized, or how much leverage the company enjoys from its financial sources. The management can know the position of the company at any point in time by using these ratios.
The financial ratio analysis assists the company, management, investors, creditors, debtors, and its customers to analyze;
- The efficiency of the operations of the company, how well it has been using its resources and assets to earn profits.
- And aid in spotting the weakness of the company, and understanding the weak links to take the needed measures for rectifying the issue.
- Help in conducting the comparison of companies of various sizes
- And help in highlighting the important information in the simplest form, giving the whole snapshot of the performance through using few numbers
- The trend analysis of the performance of the company
The Ratio analysis also has its limitations as well. Attention should be given to the limitations of the model as well as the misinterpretation can become misleading for an investor, or management. The ratio analysis is mostly dependent on a reference point. It means that for making it meaningful, the ratios need to be compared to its historical values, forecasts or of similar firm’s values (Wilson, Hill and Glazer).
Other than this, the ratios mostly by themselves tend to be meaningless. The separators are to be considered as an indicator, and for getting the whole picture of the performance of a firm, it has to be combined with several others. Because of the seasonal factors, there is a possibility that certain accounts would increase or decrease at the end of the year making the year-end values to be misrepresentative. The changes may aid in distortion of the value of the ratio. It makes room for the use of average values where available.
Moreover, the ratios are also subject to limitations of the accounting methods employed by a firm. The use of different accounting method may cause immense changes in the ratios. Ratios also do not comprehend the whole meaning of the values and thus can become misleading. For example, a current ratio for a year in which loan has been taken for the expansion will seem as screwed up. However, it is to be noted that the expansion aspect is not considered in this ratio. (Beaver, Correia and McNichols) The ratio analysis thus can be said a quantitative analysis and does not include qualitative aspects of company performance. The Rate of inflation is also another major problem which is disregarded in the ratio analysis. Furthermore, the comparison of the ratios from different industries can be highly misleading as the different industries may have different market structures, different dynamics, and different regulatory bodies affecting their accounts and consequently ratios.
As there are different types of ratios, the use of these ratios varies as well. The users of these ratios also vary. The Short-term lenders would prefer the liquidity ratio like current ratio, quick ratio or the acid test ratios. It is because they are more interested in the ability of the firm to pay off its short-term liabilities (Tracy). The Long-term debtors, on the other hand, are more concerned about the ratios related to the long-term debt including the Debt to Total Assets ratio, the Debt to Equity ratio, and the Liquidity ratio of current and quick ratio. It is because of the reason the long-term lenders are more concerned with the ability of the firm to repay its long-term debt and the capital required for running the operations. The stockholders prefer the ratios which show the return on their invested capital and show the health of the company. These include the ratios like Return on Assets, Profit margin, Operating Margin, Return on equity, Price per earnings ratio, Dividend payout ratio, Earnings per share ratio, etc.
EXAMPLE
The example of these ratios is shown below in the table showing the compression between Samsung and Apple Inc. Whichever the ratio, the interpretation of the ratio is dependent on many factors, including time period, industry, the context of reference, comparison reference and industry similarities (Morningstar.com).
| AAPL | SSNLF | |
| Current Assets | $ 106,869 | KRW 141,429,704.00 |
| Current Liabilities | $ 79,006 | KRW 54,704,095.00 |
| Current Ratio | 1.35 | 2.59 |
| AAPL | SSNLF | |
| Net Income | $ 45,687 | KRW 22,726,092.00 |
| Total Assets | $ 321,686 | KRW 314,606,735.00 |
| Return on Assets | 0.14 | 0.07 |
| AAPL | SSNLF | |
| Total Debt | $ 193,437 | KRW 75,749,996.00 |
| Total Equity | $ 128,249 | KRW 186,424,328.00 |
| Debt to Equity Ratio | 1.51 | 0.41 |
| AAPL | SSNLF | |
| Total Debt | $ 193,437 | KRW 75,749,996.00 |
| Total Assets | $ 321,686 | KRW 314,606,735.00 |
| D to A Ratio | 0.60 | 0.24 |
| AAPL | SSNLF | |
| Interest Expense | $ 1,456 | KRW 351,009.00 |
| Net Income | $ 45,687 | KRW 22,726,092.00 |
| Interest Coverage Ratio | 31.38 | 64.75 |
| AAPL | SSNLF | |
| Sales | $ 215,639 | KRW 201,866,745.00 |
| Account Receivables | $ 15,754 | KRW 24,279,211.00 |
| Receivable Turnover | 13.69 | 8.31 |
| AAPL | SSNLF | |
| Cost of Goods Sold | $ 131,376 | KRW 120,277,715.00 |
| Average Inventory | $ 2,241 | KRW 18,582,648.50 |
| Inventory Turnover | 58.64 | 6.47 |
| AAPL | SSNLF | |
| Net Income | $ 45,687 | KRW 22,726,092.00 |
| Net Sales | $ 215,639 | KRW 201,866,745.00 |
| Net Margin | 0.21 | 0.11 |
(Morning Star Apple Inc.) And (Morningstar.com Samsung)
Work Cited
Beaver, William H., Maria Correia and Maureen McNichols. Financial Statement Analysis and the Prediction of Financial Distress. Now Publishers Inc, 2011.
Fridson, Martin S. and Fernando Alvarez. Financial Statement Analysis: A Practitioner’s Guide. John Wiley & Sons, 2002.
Morning Star. “Apple Inc.” Morning Star. Morning Star, 22 May 2018. Web. 22 May 2018. http://www.morningstar.com/stocks/xnas/aapl/quote.html.
Morningstar.com. “Samsung Electronics Co Ltd.” Morning Star. Morning Star, 22 May 2018. Web. 22 May 2018. http://www.morningstar.com/stocks/pinx/ssnlf/quote.html.
Tracy, Axel. Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. Business & Economics, 2012.
Wilson, Randal, Arthur V. Hill and Hillel Glazer. Tools and Tactics for Operations Managers (Collection). FT Press, 2013.
+447462439809