The purpose and importance of financial ratios and financial analysis.
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.
The Purpose of Financial Ratios and Financial Analysis
Once financial statements (balance sheets and revenue statement among other statements) have been prepared, the next step is performing financial analysis. Financial analysis describes the process of identifying and evaluating a company’s financial data (from financial statements), and then making comparisons among different items or entries in either the same financial statement, across multiple statements or across the entire company. Accountants employ three key methods during the analysis of financial statements: horizontal analysis (trend analysis), vertical or common-size analysis, and ratio analysis. This paper focuses on ratio analysis which allows business owners and other users of financial statements to simplify information in the financial statements, identify relationships between different items in the statements, more importantly, compare the business’s financial performance and position across as well as with its competitors. Further, the paper examines the importance of financial ratios and financial analysis, their limitations, and the ratios that each user of financial statements would prefer.
Purpose and Importance of Financial Ratios and Financial Analysis
Financial analysis plays an instrumental role in investment and financial decision-making process in a business. When used internally, the analysis provides deeper insights into such aspects of business operation as employee performance, credit policies, effectiveness of new strategies, and the efficiency of operations. Financial analysis can also be used externally to assess the credit-worthiness of borrowers and areas of potential investment. As aforementioned, one of the popular financial analysis methods or techniques in many companies today is financial ratio analysis. According to Faello (2015), a financial ratio, just like other ratios, comprises of a numerator and a denominator, and thus are important for determining relationships between two or more financial amounts obtained from the financial statements such as the balance sheet and income statement. Some of the most useful financial ratios include liquidity ratio, leverage ratios, repayment capacity ratio, profitability ratios and efficiency ratios (Lee, Lee & Lee, 2009; Brealey, Myers & Marcus, 2012).
The fact that financial ratios relate two or more financial amounts or items obtained from the same or different financial statements means that they are important in explaining a firm’s financial statements (Faello, 2015). For instance, with the help of financial ratios, profitability ratios in particular, a firm is able to benchmark its performance with other firms within the industry. Moreover, ratio analysis provides financial statement for users with unique opportunities to identify underlying issues with a firm’s liquidity, profitability, inventory management, debt position and other aspects of the firm’s operation. This ability of financial ratios to assess a company’s performance and allow for inter-firm comparison and benchmarking suggests the crucial importance of the ratios in assessing the overall risk of the company.
Financial ratios are also useful in debt management as they allow firms, as borrowers, to monitor their activities and ensure their operations are in line with the terms of the debt contract. In most cases, lenders impose accounting terms in their debt contracts in order to limit the “borrower’s value-reducing activities” (Faello, 2015, p. 76). Terms of the debt may, for example, require the firm to maintain a current ratio not less than 2:1, and thus influence the way the firm manages its liabilities and assets.
Financial statement users, including managers and potential investors, also find financial ratio analysis more important when it comes to forecasting the firm’s performance. One of the key features of financial ratios is that they are based on the firm’s past financial data over time, and thus can form the basis of trend analysis. This means that users of financial statements will not only understand the company’s historical performance, but will also be in a position to envision its performance and position in the future.
Limitations of Financial Ratio Analysis
From the ongoing discussion, financial ratio analysis is a useful tool if the financial user is trying to understand trends in the firm’s financial performance, make inter-firm comparisons, and interpret various aspects of its business operations. However, there are various limitations in ratio analysis that if not understood can potentially make results and conclusions misleading.
First, financial ratios are based on financial data on two or more items from financial statements. This means that obtaining incorrect results is highly probable due to possible misstatements that may result from human error when transferring financial data and values from financial statements to financial ratios. Moreover, since some managers manipulate their accruals to portray their companies positively, the “window dressed” values can pass into the ratios and lead to incorrect conclusions about a company’s financial performance and position.
Additionally, financial ratios obtained from financial statements of a given company are a function of the accounting methods, principles and classifications that have been chosen by the company (Faello, 2015). Since these company-specific accounting principles and financial reporting frameworks are subject to change, the use of financial ratios as the basis of making inter-firm comparisons is greatly compromised. Third, ratio analysis is more meaningful if it allows for trend analysis rather than simply analyzing the results of a given fiscal year. However, the possibility of trend analysis is sometimes non-existent in practice.
Moreover, ratio analysis is based on the historical financial information and thus are ideal for explaining a company’s financial performance in the past. This makes the ratios less useful to potential investors and other financial statement users who are more interested in information the company’s current and future performance. Financial ratio analysis also fails to consider such aspects as inflationary effects, seasonal effects and changes in accounting policies and principles. Lastly, the methodologies and frameworks for calculating different financial ratios are not standardized. Looking at Return on Assets (ROA), for example, some financial analysts compute the ratio by dividing net income by average assets, whereas others calculate the ratio by dividing the operating income by the total assets (Jan, 2019).
Ratios that Each Party/Stakeholder would Prefer
Different parties/financial information users are more interested in different financial ratios. For instance, shareholders would prefer or be interested in such ratios as return on invested capital (ROI), dividend ratio, operating ratio and earnings per share among other financial ratios. This is because these ratios measure the business’s profitability, which is the investors’ biggest concern. On the other hand, the government, as another important user of financial ratios would be more interested in Gross Profit Ratio, production capacity utilization, Net Profit to Sales, and Net profit ratio because the ratios will help determine the amount to be taxed as well as whether the firm is eligible for government incentives such as tax relief. For management, stock-turnover ratio, turnover to working capital, operating ratio, current assets to fixed assets and debtors’ turnover ratio among other ratios would be more relevant because the ratios assess business profitability and efficiency in financial management. The last key stakeholder, creditors, would prefer access to liquid ratio, Debt to Equity ratio, current ratio, capital gearing ratio, and proprietary ratio since the ratios depict a firm’s liquidity and solvency position, thereby proving its eligibility for a loan.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2012). Fundamentals of corporate finance. McGraw-Hill/Irwin.
Faello, J. (2015). Understanding the limitations of financial ratios. Academy of Accounting and Financial Studies Journal, 19(3), 75.
Jan, A. (2019, July 11). Advantages and limitations of ratio analysis. Retrieved from https://xplaind.com/425487/advantages-limitations
Lee, A. C., Lee, J. C., & Lee, C. F. (2009). Financial Analysis, Planning and Forecasting: Theory and Application Second Edition. World Scientific Publishing Company.