Financial ratios are considered to be tools that are used in assessing the relative strength of businesses through the process of performing simple calculations on items that are found on the income statements, cash flow statements, and the balance sheets. Ratios aim at measuring the liquidity, profitability, stability, and operational efficiency of the company, thus providing investors with more information as compared to the raw financial data.
The Purpose and Importance of Financial Ratios and Financial Analysis
The main purpose of financial ratios is to provide a standardized method for comparing industries and companies ( Sharan, 2009) . In other words, the application of ratios helps at putting all the companies on a relatively equal field where they can be judged on the basis of their performance rather than based on their sales volumes, size, or market share. Financial ratios are vital because of the fact that they go beyond the financial numbers and determine how good the business is at finding business and making profits.
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Financial analysis using the ratios is vital in determining the trend of a particular industry against all the players in the industry ( Baker, 2 005) . Businesses can use the benchmarks of the industry to develop their strategies and measure their own performance against that of the industry as a whole.
Fundamental analysis is the term that is given to the application of financial ratios when determining the relative strength of businesses for the purpose of investing. A careful analysis of the ratios of the company is important in revealing the companies that have the fundamental strength to increase the value of their stock over time, which is a potentially profitable opportunity, while at the same time pointing out the weaker players in the market.
Finally, ratios aim at providing guidance when preparing a presentation or creating business plans for investors and lenders. Using the industry trend as the baseline, businesses can set performance goals that are based on specific ratios to provide investors with a glimpse into the potential of the new company. In addition, ratios are important in serving as an impetus for strategic change in the company, providing management with the feedback and guidance because of the fact that ratio valuation change as the organization changes. They keep managers up-to-date by revealing the financial opportunities and weaknesses.
Weaknesses of Financial Ratio Analysis
Even with its advantages, financial ratio analysis has its limitations that include the fact that many large firms often operate different divisions that are found in various industries. It means that the companies find it difficult to find a meaningful set of industrial average ratios. In addition, inflation has the risk of distorting the balance sheet of the company ( Gibson, 2013) . In such cases, the profits are often affected and thus the ratio analysis of the company over time needs to be interpreted with judgment.
Another limitation of financial ratio analysis is the fact that diverse accounting practices can interfere with the comparisons even for the same business and thus result in the false analysis . In addition, the analysis is often based on historical data which can have a negative effect on the accuracy of decisions that are made based on the information. Finally, it may be hard to determine if a company is weak or good if it has some good and some bad ratios.
Generally, ratio analysis needs to be conducted in an intelligent manner so that it can provide insightful information for the users.
Users of Financial Ratios
There are many types of financial ratios that are commonly used in practice. However, not all of them are used by everyone on a regular basis as some are useful for some user groups as compared to others ( Khan, 2007) . For example, the management team of the company is often not interested in the results but with the cause. It is mainly because even though other stakeholders do not have the control over the working of the firm, the management has control. All the other stakeholders question the management team and thus try to get information on the ratio. They often create the performance ratios such as the profitability ratios and compare with the previous performance to learn from the past and determine the trend.
Shareholders are also users of financial ratios and they are mainly concerned with the profitability ratios. They prefer the ratio because it helps in determining if the investment is risky and if they can gain maximum profits. For example, the return on equity helps in determining the number of profits that they would get from their investments on equity. Any sign of mismanagement helps them to act in good time. Finally, suppliers and debt holders are often interested in the liquidity and cash flow ratios of the company because they are concerned with the ability of the company to pay them the amount promised at the promised date ( Goel, 2016) . They are concerned with the liquidity of the company so that they can take action such as supply cutbacks in case of liquidity issues. For example, a low current ratio indicates that the company does not have enough current assets to cover its current liabilities, which is a concern to lenders and suppliers.
Conclusion
From the analysis, it is evident that the ratio analysis is vital for companies in determining their performance so that managers can be able to make the right decisions. Other stakeholders also use the information to make decisions about whether to deal with companies or not.
References
Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management: A Practical Guide . Oxford: Blackwell Pub.
Gibson, C. H. (2013). Financial reporting & analysis: Using financial accounting information . Mason, OH: South-Western Cengage Learning.
Goel, S. (2016). Financial ratios . New York: Business Expert Press .
Khan, M. Y., & Jain, P. K. (2007). Financial management . New Delhi: Tata McGraw-Hill.
Sharan, V. (2009). Fundamentals of financial management . Delhi: Pearson Education / Dorling Kindersley (India.
