Financial Ratio Analysis: The Relative Importance of Financial Ratios

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The notion of financial ratios refers to the coefficients that are calculated considering a company’s financial statements data. Financial analysis is conducted to evaluate the overall performance of a business and the efficiency of its financial operations. The present essay elaborates on the purpose of financial ratios, discusses the strength and limitations of financial ratio analysis, and explains which ratios will be preferred by different types of users.

The importance of financial ratios lies in the fact that they enable their users to evaluate the performance of companies. This way, by analyzing the financial ratios of one organization, it is possible to see whether it copes better than its competitors or losses to them. The analysis conducted by Prawirodipoero et al. (2019) reveals that companies could use financial ratio analysis for various purposes. For example, financial ratios could assist in predicting a crisis, bankruptcy, and returns (Prawirodipoero et al., 2019). In addition to that, financial ratio analysis is an indispensable component of a company’s financial planning process (Prawirodipoero et al., 2019). Additionally, Ptak-Chmielewska and Matuszyk (2018) emphasize financial ratios could help conduct a more profound analysis of the preceding mistakes and conditions and, hence, escape the same unfavorable situations in the future. According to Alqam et al. (2021), entrepreneurs should also consider financial ratios when making investment decisions. From this, it could be inferred that financial ratios are needed to check a company’s performance and realize whether its strategies and business plan require immediate alterations.

Even though financial ratio analysis is a great way to evaluate the efficiency and profitability of a company, predict crises, and uncover mistakes, this method still has several limitations. The first limitation is related to the fact that financial ratio analysis is based on a company’s historical data. Therefore, even though it is possible to calculate an overall trend based on the past data, there is no guarantee that this prediction will coincide with reality. That is because the financial ratio analysis per se cannot adequately estimate the influence of certain external factors that might cause a crisis or bankruptcy.

The second problem with financial ratio analyses is that they are based on the interpretation of financial statements that could easily be manipulated. As it is noted by Nyakarimi et al. (2020), even strong accounting standards fail to prevent financial statements manipulation by those who are interested in presenting better results than they actually are. Therefore, an analysis based on manipulated data fails to reflect the real performance of a company, and this, in turn, might lead to severe consequences.

As it has already been mentioned above, a financial ratio analysis could be conducted to compare the performance of competing companies to see whose business is going better. In this case, the logical limitation is that the needed information on competitors performance might be unavailable. Consequently, the financial ratio analysis will illustrate a company’s performance, but this information will be taken out of context. Still, at least, financial ratio analysis could be used to compare the evolution of a firm’s performance.

Another limitation is topical for the companies that produce goods or services, the demand on which is affected by the seasonal factors. For example, this might be a small company that manufactures Christmas decorations. In this case, financial ratio analysis cannot be adjusted to the seasonal changes in demand and supply. Therefore, the results of such ratio analysis might be misleading. However, this point is critical only for some part of companies that are affected by seasonal factors.

There are several types of financial ratios; the most basic are profitability, liquidity, leverage, market, and debt ratios. Short-term lenders are more likely to use liquidity ratios that show the ability of a company to repay its debts without delays. For example, the group of liquidity ratios includes such factors as a current ratio that is calculated as current assets divided by current liabilities. The higher the ratio is, the higher a company’s ability to cover its liabilities. Hence, this ratio will show a short-term lender whether it is profitable to issue a loan for a company.

Long-term lenders, in their turn, would prefer to see the leverage ratios of a company. This group of ratios is also related to a company’s ability to meet its financial liabilities. The difference with the previously discussed liquidity ratios is that leverage ratios are concerned with the ratio between the total assets of a company and its debts. For instance, such a leverage ratio as a debt-to-equity ratio shows whether a company increases its obligations or not. A high ratio informs a long-term lender that this company might go bankrupt because its debts are rapidly growing.

A company’s stockholders would be concerned with its profitability ratios because they show whether it is reasonable to invest in a company. More precisely, as it follows from the name, profitability ratios indicate the capability of a business to generate profits. For example, decreasing profit margins that are net income divided by revenue might mean that a company loses the market competition or experiences a sharp rise in production costs.

To conclude, financial ratios are highly effective and informative tools to evaluate a company’s performance. The importance of financial ratios for stockholders and lenders is that ratios could show them whether a company is profitable and whether it makes sense to invest in it and lend money to it. At the same time, it is necessary not to bear in mind that financial ratios analysis has several limitations, including manipulation of financial statements, inability to predict the future accurately and consider seasonal factors’ influence. However, these limitations could be mitigated through a more thorough control over the interpretation of the retrieved results.

References

Alqam, M. A., Ali, H. Y., & Hamshari, Y. M. (2021). The relative importance of financial ratios in making investment and credit decisions in Jordan. International Journal of Financial Research, 12(2), 284-293.

Nyakarimi, S. N., Kariuki, S. N., & Kariuki, P. (2020). Financial statements manipulations using Beneish Model and Probit regression model: A case of banking sector in Kenya. European Online Journal of Natural and Social Sciences, 9(1), 253-264.

Prawirodipoero, G. M., Rahadi, R. A., & Hidayat, A. (2019). The influence of financial ratios analysis on the financial performance of micro small medium enterprises in Indonesia. Review of Integrative Business and Economics Research, 8, 393-400.

Ptak-Chmielewska, A., & Matuszyk, A. (2018). The importance of financial and non-financial ratios in SMEs bankruptcy prediction. Bank I Kredyt, 49(1), 45-62.

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BusinessEssay. 2023. "Financial Ratio Analysis: The Relative Importance of Financial Ratios." January 9, 2023. https://business-essay.com/financial-ratio-analysis-the-relative-importance-of-financial-ratios/.

1. BusinessEssay. "Financial Ratio Analysis: The Relative Importance of Financial Ratios." January 9, 2023. https://business-essay.com/financial-ratio-analysis-the-relative-importance-of-financial-ratios/.


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BusinessEssay. "Financial Ratio Analysis: The Relative Importance of Financial Ratios." January 9, 2023. https://business-essay.com/financial-ratio-analysis-the-relative-importance-of-financial-ratios/.