Financial ratio analysis is a powerful tool for users as it simplifies financial statements' comprehension. The ratios help the users in understanding the financial variation of the organization. Using the analysis of the financial ratios allows the users to acquire in-depth information about the business's financial life (Rashid, 2018). For instance, the total debt ratio helps one understand the use of debt in a business's capital structure; that is, the higher the debt ratio, the more debt the business has. Thus, the financial ratios are remarkably useful indicators of a business's financial situation and performance; and despite being vital, the user should use them prudently to get a clear insight.
The Purpose and Importance of the Financial Ratios
The financial ratios and analysis have the purpose of measuring the business's profitability by using metrics to show the profit results at various points on the balance sheet. The gross profit margin analysis enables the business to measure the productivity of the manufacturing or services operations after deducting the material cost of production and direct labor (Arkan, 2016). The ratios also enable the firm to determine its net profit after subtracting all the firm's expenses. The ratios and analysis also act as indicators for liquidity by determining the firm's ability to pay the bills promptly and fund the operations. Organizations use different measures such as current ratios, acid tests, and working capital to analyze whether they have positive cash flow.
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The ratios analysis also has the purpose of determining the leverage ratios of the business. For instance, lenders often use the debt-to-equity ratio to gauge the risks of extending more credit to the businesses. Subsequently, debt-to-assets ratios enable the lenders to understand the amount of assets financed by the debt instead of using the owner's equity. Another purpose is determining the performance of operations by using metrics to indicate how well an organization turns over the assets in its cash flow cycle (Arkan, 2016). For example, accounts receivable turnover can be used when measuring the firm's efficiency at collecting payments from the clients. The organizations must collect the receivables quickly to settle bills and purchase more inventory.
Financial ratios analysis facilitates the comparison between different businesses and between organizations that differ in size. For example, investors often use different companies' price-earnings ratios to gauge their earnings trends to make investment decisions. The ratio analysis offers a comprehensive and excellent tool that facilitates investment decisions (Rashid, 2018). For example, when an organization needs capital to finance its asset, investors will analyze its company's current to evaluate the organization's ability to withstand financial crises in the short term. Similarly, creditors evaluate the firm's profitability ratios to understand the profit that the organization earns before disbursing the loans.
The ratios also display the business's performance, such as strengths and weak points. The displacement of the performance enables the firms to acknowledge areas or departments that may require substantial efforts, upgrades, and analysis. For example, a high inventory turnover ratio can inform the management that the organization has experienced unexpectedly strong sales.
The limitations of the Financial Ratios
Despite the various advantages and purposes, the financial ratios are only good based on the data and information used for comparison. Therefore, ratios analysis has some limitations; first, they are insufficient as a source of evaluation regarding the future sine. They only explain the interactions that involve past data, whereas most users are concerned about the current and upcoming information. The ratios provide a short-term sign or clue of the firm's strengths and weak points (Faello, 2015). The ratios analysis is also inefficient when used in isolation because it does not give a full financial evaluation. Thus, the ratios should only be applied as part of the analytical model in the organization.
Also, using the financial ratio analysis exceeds complexity since a single financial ratio does not provide a consistent conclusion. Investors and creditors must analyze more ratios to receive an appropriate action. For instance, profit margin ratios and return on asset ratios do not fully incorporate the opportunity cost of risk. Subsequently, the return on equity ratio does not include the cost of capital investments in its calculations when generating earnings. The ratio analysis only depends on accounting information based on the historical coast; the result may lead to distortions when measuring organizational performance (Faello, 2015). For example, modification of price during the run period may fail to impact the calculated ratio because of the failure to include financial changes in the financial statement. Thus the failure to involve the fair value data on the company's financial condition can result in inaccurate assessments.
Another limitation is the inflation factor which may render the comparison of the ratio analysis inaccurate. The choice of accounting tool can dramatically impact the valuation ratios when prices rise because organotin often use different inventory valuations such as average cost, LIFO, FIFO. For instance, one organization may use LIFO in its calculation while another one may use FIFO; in such case, the results of some ratios such as gross profit margin and inventory turnover would become disparate when prices increase. The value-relevance concerning the differences of the ratios is quite sensitive to recession.
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 prefer using the current ratio because it reduces their risk. The current ratio is calculated by dividing the current assets with the current liabilities. The results give the users adequate information concerning the company's liquidity and the efficiency of paying short-term obligations using current resources (Kadim et al., 2020). Often, the lenders will prefer the division's result to be greater or equal to one that will indicate that the current asset has an equal amount with the current liabilities.
On the other hand, the long-term lenders use debt-to-total-assets ratios to get the percentage of the firm's assets financed with long-term debt. The ratios enable the lenders to get the general financial measurement of the organization's longtime financial position. Often the creditors will prefer the ratio of or less than 0.5 because it shows that the business is good financially. However, the stockholders will choose the return on equity ratio to calculate the organization's ability to generate income from their investment or equity (Kadim et al., 2020). Normally, the higher return signifies that the organization is in a better financial performance.
Conclusion
In light of the discussion, the financial ratio analysis is a vital tool for users of financial statements such as investors and creditors. The ratios ease the financial report's comprehension and facilitate the possibility of comparisons between distinct firms. Despite being insufficient in themselves as a tool of judgments, it is also appropriate to acknowledge that the financial ratios are still the most appropriate tool in the financial world. Therefore, the organizations should understand how to apply them appropriately and understand how to deal with some of the limitations.
References
Arkan, T. (2016). The importance of financial ratios in predicting the stock price trends: A case study in emerging markets. Finanse, Rynki Finanaswe, Ubezpieczenia , (79), 13-26. https://doi.org/10.18276/frfu.2016.79-01
Faello, J. (2015). Understanding the limitation of financial ratios. Academy of Accounting and Financial Studies Journal , 19(3), 75. https://www.google.com/url?sa=t&source=web&rct=j&url=https://www.abacademies.org/articles/aafsjvol19issue32015.pdf&ved=2ahUKEwizgZPu3OvvAhVpaRUIHZ4mCrQQFjAAegQIAxAC&usg=AOvVaw0l40xMRPxjWmdu9tw0-EPx
Kadim, A., Sunardi, N., & Husain, T. (2020). The modeling firm's value is based on financial ratios, intellectual capital, and dividend policy. Accounting , 6(5), 859-870. https://doi.org/10.5267/j.ac.2020.5.008
Rashid, C. A. (2018). The efficiency of financial ratios analysis for evaluating companies' liquidity. International Journal of Social Science & Educational Studies , 4(4), 110. https://doi.org/10.23918/ijsses.v4i4p110
