Financial ratios utilize the information stored in financial statements to perform a financial analysis of an organization. There are numerous financial ratios that apply to specific industries, operations, or parameters that an organization needs to measure. Some of the financial ratios that organizations could use include liquidity ratio, profitability ratio, leverage ratio, and asset management ratio. The results of financial analysis are critical to the management as it helps them make key operational decisions. However, financial ratios depend solely on financial statements, do not compute for inflation, and vary in application according to operations limiting their effectiveness. A company should weigh the benefits versus the limitations of financial ratios before applying them as a base for its decisions.
Benefits of Financial Ratios and Analysis
To assess the financial performance of an organization, the management applies tools such as financial ratios in quantitative analysis. Financial analysis helps an organization to identify its financial position and ability in a market. Kim and Im (2017) note that companies use financial evaluation results to compare and benchmark performance among their competitors. An organization should conduct the practice regularly to identify its strengths and weaknesses.
Financial ratios help the management identify the historical performance and predict their financial future. The results act as guidance for short-term and long-term decision-making processes. Qualitative analysis can either be performed internally or externally (Kim and Im, 2017). The internal analysis anchors decision-making processes within a firm, while the external is used by investors who evaluate the performance of a firm before their commitment.
Limitations of Financial Ratios and Analysis
On the other hand, financial ratios have limitations that may hinder their full consideration during comparison and corporate decision-making. One of their major shortcomings is the primary use of information based on financial statements. This is a limitation in that financial figures are subject to manipulations, approximations, deficiencies, or even diversity in practice. Financial managers can consciously or unconsciously make errors on financial statements, which could reflect in analysis results leading to wrong conclusions.
Additionally, financial ratios can cause faulty comparative conclusions among similar firms that use diverse operation procedures. The application of particular financial ratios over others is dependent on the method and procedure of operations used in a firm. For instance, a company using first in first out method (FIFO) to account for their inventory may use a different accounting method from one using last in first out (LIFO). Some of the financial aspects that could be faulty include estimating the life of a company’s assets, preliminary expenses, amortization of intangibles, and depreciation. Financial ratios should not be used when comparing the performance of organizations without considerations of the firms’ mode of operations.
Changes in the value of a currency over time due to inflation may not be recorded in financial statements used to perform financial analysis. Svynarenko et al. (2019) note that the value of goods purchased in different economic times are not accurately recorded, thus deceptive and have distortions. Financial gains such as sales income or accrued profit and other critical figures are bound to change when their values are changed according to the appropriate rate of inflation.
When using financial ratios, the organization should pay attention to the mode of operations, industrial situation, general economics, size of the organization, and diversity of the products. These factors may vary in different organizations affecting the accounting methods used. The mode of computation also impacts how accounting ratios are utilized. In other words, different accounting methods use varying figures in the numerator and denominator in certain financial ratios. Hence, financial ratios are not accurate for making decisions among different firms, even when the situations are similar.
Consequently, unique financial ratios are used in diverse scenarios by firms mainly according to their purpose and method of operations. Considering different users of financial ratios, such as long-term lenders, short-term lenders, and stockholders, each would prefer a unique ratio in their operations. Short-term lenders use a liquidity ratio since it provides information about a firm’s ability to meet its short-term goals (Haralayya, 2021). To reduce their financial risk, short-term lenders would prefer to have a high current ratio. This means that a higher amount of assets can easily be liquidated in case of a risk. Liquidity ratios reveal to short-term lenders the number of current assets that could easily be converted to cash in case of default. Such current assets include inventories and account receivables.
Shareholders also use the liquidity ratio to calculate their gains. Unlike short-term lenders, shareholders prefer to have a low current ratio (Kourtis et al., 2019). For instance, when a firm has a high current ratio, it means that most of its assets can easily be liquidated. On the other hand, a low current ratio means most of the resources are being utilized or invested and could yield profit.
On the contrary, long-term debtors prefer the use of financial leveraging ratios to assess the financial position of a firm. The financial leveraging ratio provides information about the long-term solvency of a firm. Kourtis et al. (2019) posited that a financial leveraging ratio differs from a liquidity ratio in that; liquidity ratio evaluates the short-term liabilities and assets while the financial leverage ratio takes into account how a firm is using long-term debt.
Without a doubt, financial ratios and financial analysis are critical elements used by the management of an organization to determine its financial position. An organization should conduct a firm’s financial analysis regularly to identify its strengths and weaknesses. Financial ratios utilize the information stored in financial statements to perform a financial analysis. However, financial ratios have limitations that may hinder full considerations while making comparisons and corporate decisions.
Major limitations of financial analysis include sole consideration of financial statements, inflation, the difference in operations of firms, and general economics. Different ratios are used by diverse users according to their needs and operations. For instance, short-term lenders and stakeholders use liquidity ratios while long-term lenders use financial leverage ratios.
Haralayya, B. (2021). Ratio Analysis at NSSK, Bidar. Iconic Research and Engineering Journals, 4(12), 170-182. Web.
Kim, J., & Im, C. (2017). Study on corporate social responsibility (CSR): Focus on tax avoidance and financial ratio analysis. Sustainability, 9(10), 1710. Web.
Kourtis, E., Kourtis, G., & Curtis, P. (2019). Integrated financial ratio analysis as a navigation compass through the fraudulent reporting conundrum: A case study. Web.
Svynarenko, R., Zhang, Q., & Kim, H. (2019). The financial burden of Cancer: Financial Ratio Analysis. Journal of Family and Economic Issues, 40(2), 165-179. Web.