One of the most important aspects of a company’s success is its finances. When finances are orderly and stable, a company is able to generate profit efficiently, expand the value of original investments, and simultaneously compensate for liabilities (Myšková & Hájek, 2017). Financial analysis and financial ratios are used to achieve those goals by accessing the company’s financial performance. Without being able to gauge financial losses and gains, it is challenging to devise necessary strategies for further development.
The Use of Financial Ratios
Financial ratios are an essential part of financial analysis. They are used in order to ascertain financial trends within a company’s structure, and they are widely preferred primarily due to their simplicity and informativity. In addition, financial ratios show variables relating to a particular industry. By using financial ratios, a company is able to create a reference point through which it understands its place in the market, its flaws, and its powers. In turn, it allows adjustment of current financial strategies and the development of new ones. They can be divided into categories of various indicators, such as profitability, liquidity, productivity, cost, capital market, capital structure, and solvency (Myšková & Hájek, 2017). Not all of these categories are strictly necessary to use while analyzing a company’s performance.
Limitations of Financial Ratio Analysis
Despite its broad area of use, financial ratios do not come without certain limitations. To use ratios means to understand their limitations lest one meets an incorrect conclusion. The first limitation of ratio analysis is that the information provided by it is historic and not up to date. The second limitation comes from the fact that ratio analysis does not take into consideration world recession. The third limitation factor is linked to the influence of the human element, and the fourth concerns the unwillingness of other companies to share their data. The fifth limitation is that a company could only be compared with a company of its size and kind (“Purpose and limitations of ratio analysis”, n.d.).
The Appropriate Use of Financial Ratios
In terms of a division of lenders into short-term lenders, long-term lenders, and stockholders, financial ratios vary accordingly. Each of these categories would require a different approach to ratio analysis depending on their goals and needs. First of all, for short-term lenders, it would be liquidity ratios, which are divided into several sub-categories. Secondly, long-term lenders would be mainly concerned with solvency ratios. Thirdly, for stockholders, the most appropriate would be profitability ratios.
Liquidity Ratios
As stated above, liquidity ratios would be preferred mainly by short-term lenders. These ratios show if a company is capable of meeting short-term commitments. Lenders need to be assured of a company’s capability to timely fulfill their agreements, and liquidity ratios help identify red flags in financial management in advance. Such red flags include the inability to pay wages and salaries on time, faulty tax payments, and poor accomplishment of other short-term goals (Aryasri. 2020). For example, if a company wants to obtain a loan, it needs to prove its creditworthiness. A lender or lenders would require a stability check since they need to be sure that their money would be returned.
Solvency Ratios
Solvency ratios could be successfully used to attract long-term lenders. In fact, they are often used by prospective lenders because these ratios allow them to ascertain whether a company is able to pay off a lasting debt or meet long-term commitments. Solvency ratios measure cash flows instead of the net worth of a company to understand how its cash flow capacity could withstand its liabilities (Aryasri, 2020). For example, to provide lenders with additional guarantees, a company can refer to the interest cover ratio, which is the number of times it can cover its interest obligation using its profits.
Profitability Ratios
For stockholders, the most appropriate way of financial analysis would be profitability ratios. Profitability ratios are defined as tools to determine a company’s ability to gain profit against its expenses and other costs related to generating the income. It essentially shows how profitable a company is and indicates funds distribution efficiency. High profitability ratios are a valuable asset for success among stockholders, and it generally means that a business performs very well (Aryasri, 2020). For example, if stockholders need to verify that a company’s infrastructure is run competently, they might use operating margin. The operating margin is a sub-category of profitability ratios that displays the effectiveness of a company’s core monetary operations. It is the portion of the profit that is dedicated to payments towards creditors, taxes, and stockholders. Therefore, the numbers confined in the operating margin would concern stockholders the most.
Conclusion
In conclusion, financial analysis and financial ratios are essential elements of business practice and establishing a healthy financial structure within a company. Despite the fact that these analysis strategies are broadly used, they possess specific limitations that their users should keep in mind. In addition, depending on the aim and circumstances of an individual lender, different categories of ratio analysis need to be employed. For short-term lenders, it is liquidity ratios; for long-term lenders, it is solvency ratios; and for stockholders, it is profitability ratios.
References
Aryasri, A. R. (2020). Business economics and financial analysis. McGraw-Hill Education (India) Pvt Ltd.
Myšková, R., & Hájek, P. (2017). Comprehensive assessment of firm financial performance using financial ratios and linguistic analysis of annual reports. Journal of International Studies, 10(4), 96–108. Web.
Purpose and limitation of ratio analysis. (n.d.). Web.