Financial ratio analysis is perhaps the oldest and most essential tool used to evaluate a company’s credit position and overall financial performance. Financial statements of a company generate a large number of ratios which analysts use depending on the company’s activity or purpose of analysis. Although the application of ratio analysis is widespread, it poses inherent limitations. The article outlines the ratio groups and the benefits of ratio analysis and explores its limitations to decide if financial ratio analysis is an effective tool.
Financial Ratios
Most analysts classify ratios into four groups: liquidity, activity, debt, and profitability ratios.
Liquidity ratios: They assess a company’s ability to repay its short-term debt. Current ratios involving current assets and current liabilities form part of liquidity ratios.
Activity ratios: They measure the company’s ability to convert its balance sheet accounts into cash. The values assess the efficiency of the company. Ratios in this group include inventory turnover, assets turnover, etc.
Debt ratios: They assess a company’s leverage levels and consequent potential risks. Ratios in this group include debt-equity, debt-assets, interest margin, etc.
Profitability ratios: They measure a company’s performance in terms of its ability to generate revenues. Ratios in this group include ROA, ROI, net profit margin, etc.
Benefits of Ratio Analysis
Simple and straightforward – It is easy to calculate ratios and arrive at useful information at an instant. Calculating the ratios involves the straightforward use of the numbers from a company’s financial statements.
Comparisons – It is possible to compare ratios over different time periods, companies, and industry. Ability to compare provides information and analysis on trends within the company and the industry. Such comparisons also provide information for decisions on financial goals and critical to success factors.
Forecasting – Companies analyze ratios to forecast decisions on expansions. For example, companies will forecast the costs of future projects depending on their ability to pay off short-term obligations. Liquidity ratios assess the ability.
Discipline – Profitability ratios, which evaluate a company’s performance also implies the evaluation of its managers’ performances. An indirect result of the ratios is making the managers adhere to the financial goals and thus, discipline them.
Limitations of Ratio Analysis
For many years, analysts have been using ratio analysis as the established technique to analyze, compare and forecast company performances. However, even such established methods have inherent limitations.
Ratio analysis depends on accounting and not economic data. It is retrospective and not prospective examination. There is ample proof that a company’s stock price movement correlates closely with cash flow measure and not income based measures.
Do the limitations outweigh benefits? They certainly do. However, financial ratio analysis is still a tool useful in assessing a company’s financial performance. Although not an adequate method, ratios can provide a functional understanding of a company’s operations, if used intelligently. It is necessary to consider external influences on the financial tool and realize the potential for distortions. Analysts need to understand the limitations in the analytical method and make the necessary modifications.
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