Set of Techniques Used to Assess the Financial Ratios of a Firm - Essay Example

?On Ratio Analysis Ratios analysis is a set of techniques used to assess the financial ratios of a firm pertaining to liquidity, debt, and profitability (Gibson 1982). The analysis focuses on the interpretation of indicators or tools or financial ratios through which an analyst can evaluate the investment worthiness of a firm (Gibson 1982). In the words of Gibson (1982, p. 18), “probably no tool is more effective in evaluating where a company has been financially and in projecting the financial future of a company than the proper use of financial ratios.” This work discusses the importance of ratio analysis and how it helps in assessing a firm and its prospects for recapitalization and continuity. Suppose we want to assess the financial health of a very large or small firm, how can we analyze the firm so our analysis can provide an insight into the basic prospects for profitability of a firm? Is the firm losing or is it profitable? Are there prospects for making the firm profitable? Is the firm worth buying? Should we sell the firm? If we are to sell the firm, at what price should our purchase price be? How large are the firm’s debts? What are its prospects for profitability? What is the firm’s net worth? These are some of the questions in which ratio analysis can help provide an answer. Gibson (1982, p. 18) pointed out that the financial “ratios can be grouped into four categories: liquidity, debt, profitability, and other” financial ratios. The liquidity ratios include the working capital ratio, and the current ratio (Gibson 1982, pp. 18-19). Some of the broad debt ratios include the debt-to-capital and the debt-to-equity ratios. The debt-to-capital ratios used by many firms include the long term debt-to-long term debt plus stockholders’ equity, short term debt plus long-term debt-to-short term debt plus long-term debt plus stockholders’ equity, and several other ratios (Gibson 1982, p. 22). Based on the work of Gibson (1982), firms have favourite or typical ratios used to assess their performance and status and it is not surprising that firms would favour certain ratios or a combination of ratios that would be more appropriate to assess the performance and status of their firms or the firms which are objects of their analysis. It also plausible that ratios can be devised based on one’s objectives although there are financial ratios that are conventionally or more popularly used to assess firm performance and status. As pointed out by Gibson (1982, p. 22), for example, “firm executives have many different opinions on how a firm debt position should be determined from the balanced sheet.” Profitability ratios include measures for earnings per share, return on equity, profit margin, return on capital, return on assets, gross margin, pre-tax margin, and operating margin (Gibson 1982, p. 23). Each type of ratio on profitability can include several specific types of measures. For example, the specific measures or ratios for profit margin include net income-to-sales, income from continuing operations-to-sales, income before minority share-to-sales, net income-to-total revenues, income before extraordinary item-to-sales, income from continuing operations and before extraordinary item-to-sales, and income before cumulative effect of change in accounting principle-to-sales (Gibson 1982, p. 24). The tone of Gibson (1982) indicates that a financial analyst may improvise ratios or measures as long as they are helpful to analysis but there are ratios that are conventionally or more popularly used by analysts for assessing liquidity, profitability, debt, or other aspects of firm or business operations. The formulas of the more popular ratios are contained in financial and accounting textbooks. Meanwhile, the ratios identified by Gibson (1982) for drawing insights on firm or business operations include dividend per share, book value per share, effective tax rate, dividend payout, price earnings ratio, and labour per hour. However, surely there are other measures that can be developed depending on the purpose for analysis and based on what are most likely relevant for the specific circumstances confronted by a business operation. Further, financial regulation both at the country and international levels can require the standard ratios that firms have to be transparent about for public scrutiny. Watson et al. (2002), however, noted that firms in the United Kingdom voluntarily disclose ratios in their annual corporate reports. Watsone et al. (2002) interpreted the voluntary disclosures being implemented by firms in the United Kingdom in terms of a need by firms to signal or communicate how they perform in the light of information asymmetry between the public and the firms and also out of the desire by firms to assert legitimacy. Legitimacy, for instance, is important because through legitimacy, firms are able to put themselves into a position where they can mobilize public funds for infusion into their firms. Of course, it is likely that one limitation of self-disclosure and ratios is that the public may not be able to validate the information or the claims made by firms and that, therefore, the public as well as the accounting and financial professions must establish regulation and self-regulation mechanisms whereby standards are agreed upon on how the ratios are measured and analyzed. In Malaysia, citing research on the matter, Abdullah and Ismail (2008, p. 4) reported that firm self-disclose ratios and analyze them to signal firm or product quality. In addition, Abdullah and (2008) Ismail pointed out that ratio analysis are used to forecast future financial variables and other predictive purposes for anticipating “corporate failures, credit ratings, assessments of risks and the testing of economic hypotheses.” Given this, another possible limitation of ratio analysis is that it may not be able to recognize that the ratios may not be stable over time, unless of course the ratio analysis explicitly covers ratio stability as part of the analysis. In conclusion, ratio analyses are important because they produce important insights on the liquidity, profitability, situation, and other aspects of a firm. The limitation of ratio analysis can be on the comparability of measures unless both the accounting and financial professions have agreed on standards. Another limitation can pertain to the stability of ratios but, on the other hand, a ratio analysis can also cover the analysis of ratio stability. References Abdullah, A. B. and Ismail, K. N. I. K., 2008. Disclosure of voluntary accounting ratios by Malaysian listed companies. Journal of Financial Reporting & Accounting, 6 (1), 1-20. Gibson, C., 1982. Financial ratios in annual reports. The CPA Journal, 52 (September), 18-29. Watson, A., Shrives, P., and Marston, C., 2002. Voluntary disclosure of accounting ratios in the UK. British Accounting Review, 34, 289-313. Read More