Use of Financial Ratios - Essay Example

?Finance and Accounting Contents Contents 2 References 6 Introduction Ratio analysis is a useful tool for analyzing a company, to predict about its future, but the result might get wrong if the factors of the variables are not taken in consideration. LEV and Sunder (1979) raised some basic questions like the structural relationship of the analyzed firms, the size of the firm; these factors are taken in consideration or not. The paper is an attempt to analyze the accuracy of the statement of Lev and Sunder using some evidences taken from real world, especially by doing the cross sectional analysis of financial ratios. Use of Financial Ratios Financial ratios are used to measure a company’s financial condition or to analyze between two companies’ financial condition (Lee, Lee & Lee, 2010, p.80). All the stakeholders of the company have interest in company’s future, that is how the company would perform in the short term or long term future, how much it is secure to invest in the company, what type of change should be introduce so that the company can perform better (Bull, 2008, p.6). When an investor wants to take the decision to invest money, certainly he wants to invest it in the most effective company, the decision he can take by using the financial ratio analysis along with other type of analysis like qualitative analysis or other type of quantitative analysis (Gibson, 2011, p.468). Critical Analysis Ratio analysis is a very widely used tool for analyze the financial stability of a firm. But there are certain problems arise when the analyst don’t take the associated factors in consideration. When the analyst is doing the performance analysis of two companies, they should remind that two companies can follow two different accounting policies. There is no single accounting standard which is being followed by the companies all over the world (Fischer, Taylor and Cheng, 2008, p.505). The taxation rules of different states, different countries vary over the world. The inflation over the world is different. A multinational company has to face different taxation policy, different inflation over the world. So when a researcher is analyzing the performance of a company using ratio analysis, he should take these factors in account. There are also technical factors associated with the analysis. Many statistical tools which are being used in ratio analysis are based on the assumption that the data are normally distributed, but in reality that doesn’t happened. For identifying the financial indicators specifically for Critically Access Hospitals the Flex Monitoring Team used 114 financial ratios as their part of research. But they found many problems when research about the industry, like Hospitals with negative current Assets or negative current liabilities was excluded from the calculation of median, but that should be included when researching about the liquidity of the industry (Flex Monitoring Team, 2005, p.17-18). A research study was performed by taking 66 listed Malaysian firms’ data for the period 1980 to 1996. The forms were taken from 3 sectors industrial sector, mixed industry and combination of industrial and property sector. From the research it has been seen that only current asset percent was conformed to normal distribution. For doing the ratio analysis effectively three type of transformation techniques were used namely square, square root and natural log. When the square and square root property were used they were found as not effective, because the variables of the ratio analysis are not normally distributed. But natural log technique is proved effective by the researcher as the process considers that the data available is not normal. The researcher proved through the research that when a ratio analysis is being performed to analyze the performance of a company or comparable analysis between two companies is done then they should address the proportionality effect on the ratio’s normality (Sori et al., 2006, p.71-81). From a survey done on U.S.A. firms it is clear a ratio can depend on different factors for different industries. The survey was done on American service and manufacturing firms. It was found that the determinants of dividend payout ratio in service sector are different than the determinants of manufacturing sector firms’ dividend payout ratio (Gill, Biger & Tiberwala, 2010, p.13). The analysts should be cautious when they are doing the ratio calculation for doing the performance analysis as the ratio of different sector can depend on different variables. When the researcher use the financial data for ratio analysis keeping in mind the associated factors affecting it, then ratio analysis becomes a useful tool for analyzing the condition of the company or the industry. The evidences show that the Dividend Yield ratio, the book to market ratio & the Earning Price ratio is not so efficient to predict returns but when it take into account of the predictive variable’s autocorrelation then the ratio calculation become significant (Lewellen, 2004, p.229). One of the important ratios to analyze a company is earning per share, but when the EPS of two different companies is analyzed then generally researchers don’t take the size of the firm in account. The number of shares issued by 2 firms is different generally so when calculating EPS, the researcher should take the size of the firm as a correlated factor. Also when an analyst is measuring the size of growth of a firm, the firm size should be taken in consideration as it is an important factor for predicting the future (Trigueiros, 1997, p.216). The analysts face conceptual & practical problem when they are doing cross sectional analysis which means that the analysis among companies belongs to different industry as the risk factors are different and the economic factors are different for different companies. So when an analyst want to do the cross sectional analysis of financial ratios then they should consider the financial variable properties to make the analysis successful (Lev & Sunder, 1979, p.202-203). Conclusion In the year 1979 Lev and Sunder stated that the practitioners and researchers often use the financial ratios without considering the theoretical part of the analysis. It is clear from the researches which were done on the basis of the above statement that if the different factors of the variables of ratios are not used by the researcher then the outcome of the study would be wrong. As the factors of the variables of ratio analysis are different for different industries and it also varies from country to country so for taking a decision based on the ratio analysis the researcher should take all the factors which affect the variable in consideration. References Lee, C. Lee, J. Lee, A. (2000). Statistics for Business & Financial Economics, Volume 1, 2nd ed. Singapore: World Scientific. Bull, R. (2008). Financial Ratios-How to Use Financial Ratios to Maximise Value & Success for Your Business 1st ed. Great Britain: Elsevier. Gibson, C. (2011). Financial Reporting & Analysis: Using Financial Accounting Information 12th ed. United States: South-Western Cengage Learning. Fischer, P. Taylor, W and Cheng, R. (2008). Advanced Accounting 10th ed. Canada: South-Western Cengage Learning. Flex Monitoring Team (2005). Financial Indicators for Critical Access Hospitals. [Pdf]. Available at: http://www.flexmonitoring.org/documents/BriefingPaper7_FinancialIndicators.pdf. [Accessed at: November 18, 2011]. Sori, Z. et al. (2006). Some Basic Properties if Financial Ratios: Evidence from an Emerging Capital Market [Pdf]. Available at: http://www.eurojournals.com/IRJFE%202%206%20Sori.pdf. [Accessed at: November 23, 2011] Gill, A. Biger, N and Tiberwala, R. (2010). Determinants of Dividend Payout Ratios: Evidence from United States. [Pdf]. Available at: http://www.benthamscience.com/open/tobj/articles/V003/8TOBJ.pdf. [Accessed at: November 23, 2011]. Lewellen, J. (2004). Predicting Returns with Financial Ratios. [Pdf]. Available at: http://mba.tuck.dartmouth.edu/pages/faculty/jon.lewellen/docs/FinancialRatios.pdf . [Accessed at: November 18, 2011]. Trigueiros, D. (1997). Non Proportionality in Ratios: An Alternative Approach. [Pdf]. Available at: http://iscte.pt/~dmt/publ/1997_Non_proportionality_in_ratios_an_alternativa_approach.pdf . [Accessed at: November 18, 2011]. Lev, B. & Sunder, S. (1979). Methodological Issues in the Use of Financial Ratios. [Pdf]. Available at: http://faculty.som.yale.edu/shyamsunder/Research/Accounting%20and%20Control/Published%20Articles/18.Methodological%20Issues/18.Methodological.IssuesJAE1979.pdf . [Accessed at: November 18, 2011]. Read More