Financial ratios are considered to be tools that are used in financial analysis. Often they act as financial indicators.
Purpose and Importance of Financial Ratios
The main purpose of financial ratios is to act as an indicator in identifying the negative and positive financial trends ( Goel, 2016) . The trend analysis aims at allowing people to develop and implement the continuing monetary plans, and also when required , make rectifications to the financial plans that are short-term in nature.
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The importance of financial ratios is the provision of a standardized method of comparing the companies and the industries. The application of financial ratios puts every organization on a comparatively equal ground for the analysts and thus they can be judged based on their performance as opposed to their size, market share, and the sales volume ( Khan, 2007) . It is worth noting that comparing raw financial figures of corporations that are in similar industry provides a narrow insight. However, ratios go past the figures to show the way companies are making profits, grow through sales, and funding of the business ( Gibson, 2012) . In addition, ratios are crucial in revealing the trends of specific industries and thus helping in creating benchmarks against which the performance every industrial player can be measured. Financial ratios are also vital in terms of helping analysts and investors communicate and evaluate the weaknesses and the strengths of individual industries and companies. A careful analysis of the ratios of a business can indicate the companies that have a fundamental strength to increase the value of the stock over time and any opportunity that is considered to be profitable while indicating the actors who are weaker in the marketplace. Finally, financial ratios are vital in providing guidance when preparing presentations or business plans for investors and leaders. More specifically, managers develop performance goals that are set time-bound in the form of precise ratios aimed at giving investors an idea of the corporation’s ability. Finally, ratios often keep managers on toes in terms of revealing the financial opportunities and weaknesses.
Purpose and Importance of Financial Ratios
The purpose of the financial analysis is providing techniques for companies to link the financial condition of the business in contrast to other companies in the industry, or among companies in an industry as compared to those in other industries. Financial analysis is important in understanding the financial position of a business, which then helps in the decision-making process. However, even with the benefits of financial analysis, they also have limitations.
Limitations of Financial Ratio Analysis
There are very crucial limits to financial ratios which, need to be analyzed such as the fact that numerous big firms often function various divisions in dissimilar industries. For such corporations, it is often hard to discover industry-average ratios that can be considered to be meaningful ( Peterson, 2012) . The second limitation is that inflation has the risk of distorting the balance sheet of the company and also the profits. Therefore, ratio analysis of a business after a period or a comparative examination of diverse ages needs to be analyzed with judgment. In addition, factors that are seasonal in nature can interfere with the ratio analysis. Having an understanding of the factors which are seasonal in nature that affect companies has the potential of reducing the possibility of misinterpretation. A good example is that the inventory can be high during the summertime when preparing for the back-to-school period the outcome is that the accounts payable of the business can be great while the ROA can be low. In addition, the different accounting practices that are often used by companies have the risk of distorting comparison levels even if it is within the same company ( Chandra, 2005) . Another limitation is the fact that it is often hard to generalize if a particular ratio is bad or good. For an instant a high cash ratio can be understood as a good signal in a company that is often seen as a growth company but, can also be a signal that the corporate has stopped to be a growth entity. Finally, companies can have bad and good ratios, thus making it difficult to determine if it is a frail or good entity. Generally, ratio analysis that is conducted in a manner that is mechanical and unthinking can be dangerous. On the other hand, if done and applied intelligently then the analysis can provide insightful information.
Users of Ratio Analysis
Often the users of financial ratios include long-term lenders, short-term lenders, and stockholders. Lenders who are short-term in nature often use the current ratio because it is an indication of the ability of the company to pay short-term obligations using the current resources. For example, a higher ratio indicates that the current obligations can be met by the business. Long-term lenders are often interested in the operating cash flow to determine the way the company is generating income. The results from the ratio provide the leaders with the real picture of the amount of cash coverage that is in a business. Finally, stockholders are attentive to the debt to equity ratio to know if the company is relying on debt financing or equity. A higher ratio, for example, indicates reliance on the debt which means that the company might use stockholders return on investment to pay the debt first before giving out dividends.
Conclusion
Financial ratios are used in assessing the relative strengths of organizations through the process of execution simple calculations on the balance sheet, cash flow statements, and the income statements. Ratios measure the organizations’ liquidity, profitability, efficiency, and stability.
References
Chandra, P. (2005). Fundamentals of financial management . New Delhi: Tata McGraw-Hill Pub.
Gibson, C , H. (2012). Financial Reporting and Analysis + Thomsonone Printed Access Card . South-Western Pub.
Goel, S. (2016). Financial ratios . New York: Business Expert Press .
Khan, M. Y., & Jain, P. K. (2007). Financial management . New Delhi: Tata McGraw-Hill.
Peterson, P. P., & Fabozzi, F. J. (2012). Analysis of Financial Statements . Hoboken: John Wiley & Sons.
