Purpose of Financial Ratios and Analysis
Financial ratios are used by two main parties which are the management and the investors. Management uses the ratio to determine the firm performance and to determine where improvements are needed. For example, the manager may realise there is low gross margin and work on ways of increasing it. To the investors, they use financial ratios to determine whether it is profitable to invest in various firms and also industries ( Beaver, McNichols & Rhie, 2005) .
Importance of Financial Ratios
Financial ratios and analysis help in determining the probable causal relation on different items after scrutinising their results ( Lewellen, 2004) . Managers use the ratios and analysis to make guidelines that guide the business and prepare an effective budget. The performances of different ratios are the ones which determine what will be allocated. The ratios are used to determine the trend over years whether the company is doing well than the previous year.
Delegate your assignment to our experts and they will do the rest.
The ratios are used to determine how effective the management is. Financial analysis of these ratios is the only sure way to know whether the current management is using the available assets and resources for the betterment of the company. It is sometimes referred to as surveyor of efficiency. It can also be used to do an inter-firm comparison between firms which are doing the same kind of business. The comparison can also be done internally between departments to determine which ones are best utilising their resources. Ratios are used to determine the short-term liquidity position through the use of liquidity ratios and also solvency position in long-term through the use of leverage or the profitability ratios. The user of the financial statements can use ratios in a number of ways.
Limitations of Financial Ratios Analysis
A comparison can only be worth where the basis of valuation between the two variables is identical. Where firms use different methods in their valuation, comparing the two firms is of no use. It is difficult to come up with the real picture even after analysing the ratios since the figure used are obtained from the financial statements and in most cases, the figures are window dressed
Ratios analysis is more meaningful if the trend is compared over a number of years instead of analysing the results of just one year (Bushman, Chen, Engel & Smith, 2004) . In many firms, there will be no one doing this; they concentrate on the current. Just because in the past the results were in a certain way, it does not guarantee that they will remain the same and that is the reason as to why they are not always effective when used in budget preparation since the business policies keep on changing.
Short-term Lenders
Short-term lenders prefer liquidity ratios. They can obtain the information they require from these ratios about the company ability to settle its financial obligations which are of a short term. The ratios which are used are current and quick ratio. Current ratio is also referred to as working capital ratio.
The current ratio is a comparison between current assets and current liabilities.
Current Ratio = Current Assets
Current Liabilities
A high current ratio reduces the risk of the lenders and hence they prefer it.
Quick Ratio
It is the acid test ratio. The current assets which are used are cash and accounts receivables
Quick Ratio= Current Assets-Inventory
Current Liabilities
Long-term Lenders
Long-term refers to any period beyond one year in accounting. A long-term creditor will be interested in solvency ratios. Solvency is the company's ability to repaying the long-term debts. The critical solvency ratios are debt to equity ratio, times-interest-earned ratio and debt ratio
Debt Ratio= Total liabilities
Total Assets
Companies with high debt ratio find it difficult obtaining additional financing (Jensen, 2005) . Most of the assets are already financed with debts. If they get financing, then it will be of a higher interest rate.
Debt to equity ratio= Total Debt
Total Equity
This is usually a ratio of the total debt to the total equity. Classification of long-term debt and equity must be done well.
Interest Coverage= EBIT
Interest Charges
The times interest earned ratio is also known as interest coverage, it shows whether the firm can repay the interest of the loan using its earnings.
Stockholders
Stockholders will require profitability ratios in deciding whether to invest or not.
Gross Profit Margin= Sales- Cost of Goods Sold
Sales
Gross Profit Margin is the profit earned on sales after considering only the cost of goods sold.
Return on Assets= Net Income
Total Assets
Return on assets measures how the assets are being utilised well in the generation of profit.
Return on Equity= Net Income
Shareholder Equity
Shareholders consider in a big way Return on Investment. It measures the profit that is yielded for every unit of cash that is invested in the company. It is the bottom line and most shareholders will consider only this ratio.
References
Beaver, W. H., McNichols, M. F., & Rhie, J. W. (2005). Have financial statements become less informative? Evidence from the ability of financial ratios to predict bankruptcy. Review of Accounting Studies , 10 (1), 93-122.
Bushman, R., Chen, Q., Engel, E., & Smith, A. (2004). Financial accounting information, organisational complexity and corporate governance systems. Journal of Accounting and Economics , 37 (2), 167-201.
Jensen, M. C. (2005). Agency costs of overvalued equity. Financial management , 34 (1), 5-19.
Lewellen, J. (2004). Predicting returns with financial ratios. Journal of Financial Economics , 74 (2), 209-235.
