Benefits and Limitations of Ratio Analysis - Essay Example

Executive Summary It is fundamentally important to eluci more on how this application works in business concepts.Ratio analysis is defined in a way that it is able to synthesize data by breaking it down in a way that it can be compared successfully. It is used in businesses by making sure that specific adjustment that relates to specific query in the business is solved instead of factoring raw numbers. In many businesses, the use of ratio analysis has been useful in knowing the future business trends. By relying on the figures over time, it is always possible for the ratio analysis to predict the future expectation of the business by taking into account the current and past business events and performances. (Lootsma 1999) Use of standard ratios has been useful in areas that may require specific kind of analysis, these areas in businesses may include gross profit margins, return on assets, inventory turnovers and earnings per share. It is always possible to trace the business historical performance, and newly hired employees should be trained on its basics and how to use it so that they may be able to know the kind of data between the company and other competitors in the past. There should be no any kind of assumption that may relate to these basic principles of these tools of analysis. When this is not considered, then serious blunders can be made while making calculations. This tool is employed in very many areas of the business operations that may include its application in various departments of the business such as accounting, finance, and marketing so as to help that particular business to make sound decision as well as refined business forecasts. The discussion will focus on the benefits and the limitations of ratio analysis besides the factors that influences the impact of such measures and meanings of the ratios. It will clear by summarizing on the practical applications of financial statements and financial ratios. Benefits and limitations of ration analysis The use of this tool in different departments of the business has various advantages that accompany its use in undertaking daily business analysis. This tool is able to make quick business analysis that includes extensive assessments of the company worth. There are complex business entities that may be difficult to tackle manually without the help of this tool that helps in simplifying any kind of complex financial books. It may be useful to any person or investors who may be having any kind of interest of knowing the history of a particular business by availing the information on business trends, company background and history of existence and market performance (Anthony, 2003). This can easily be achieved by factoring in long term ratio analysis concepts. By availing any kind of information about a company in the quickest way possible, this has enabled people have a snap idea of the company status. This kind of ideas can be beneficial in furnishing investor with useful information whenever they need it as well enabling the top management of the company to make decisions that are geared towards developing strategies that are beneficial for the company growth (Anthony, 2003). The most useful beneficial factor of this tool is to offer relevant information of company financial stability; this has been very useful information that may be important in making kind and wise decisions of loan advancements to clients or when the company itself is fit for loans from other financial institutions. However, there are instances when it is important to compare the performances of business competitors as well as different departments within the business. The information availed can be used in making sound investments in the business, again it may relatively impact on the kind of plans that should be executed for business improvements and marketing decisions. When all these factors are put in place, then the use of ratio analysis can be important in assessing the performance of the business competitors (Lootsma, 1999). It is relatively important and cheaper to know the business worth by using this tool in business analysis, although the kind of information and work may not be thorough as needed , but in many instances it helps in giving that basic information for thorough business worth analysis. By doing this, it is very easy to detect any kind of problem that the business may be experiencing or area of business finances that require adequate exploration. The accuracy that the financial statements are engaged in is the major determinant of the effectiveness of this tool, therefore it is important to have accurate financial statements. Despite all the merits that this comes with, there are other demerits that it comes with. The ability of ratio analysis to give precise answers in terms of company comparison is hindered by the fact that many companies operate in different set ups as per concerns the regulation systems and market structures. The information that may be given there in thus may not be that accurate since these companies don’t have a common business playing grounds. This tool has in built assumptions and estimates that it relies on to give accounting information; however, it is necessary to note that these actors do affect the preciseness of the information required since accounting standards and the laid down policies don’t allow this kind of actions that affect comparability. In as much as the ratio analysis is able to trace the business history in the past, many business practitioners are less concerned with the past, but there focus is on the current and future business situations. Financial statements There is a connection between the kind of business trend and ration analysis that helps in executing financial analysis in financial statements. The trend analysis is able to trace the business into its past performance by linking trend and ratio analysis in providing a tool that is able to determine profitability analyses or financial reviews. By providing benchmarks analysis the company can easily compare its data with other data. At the end of the year when the company is closing its financial books, the trend and ratio analysis also uses the inputs of financial statements since this is the final financial image after a particular period in terms of accounting reports. It is the function of the trend analysis to find changes of other currencies like dollar in the financial statement and also the changing percentages in some commodities in the company (Fraser, 2001). The major advantage of this is the fact that the information update is enabled and improvement highlighted in certain business areas. The use of ratios at time is very difficult thus the already generated ratio computations can be used in the following financial statements to factor in the trend analysis. In financial statements, ratio analysis and trend can help in managing stock prices and tracing them to help in getting new purchases. It can trace and help in matching the stock price with strong financially stronger companies. The use of ratio analysis in relation to financial statements is employed in ways that realize the business successes as well as failures so that the progress of business can be checked. There are several ways that ratio analysis can be perfectly applied; use of balance sheet ratio analysis can be used in areas where liquidity, leverage and solvency of the business need to be measured. Many factors revolve around this take into consideration the use of liquidity ratios that avails the information that the assets can be turned into cash (Anthony, 2003). The most ratios involved here include others such as current, quick and working ratios moreover, the current ratios helps in knowing the financial strength of the business and it should lay out clear the ability of the business to pay the its debts. (Anthony & Breitner 2003) It is the ratio of total current assets and total current liabilities. In the eventuality of low business current ratio it is always prudent to swing into action of raising it by facilitating payment of debts, increase of the company assets, conversion of non assets to current assets , enable equity distribution to increase your current assets and by ploughing profit back into business. Use of quick ratios or ‘acid tests’ is always very important to help in checking liquidity in a way that it excludes inventories. Use of working capitals ensures a better cash flow rather than mere ratios, while in other areas it is much applicable especially in banks where the use of net working capital so as to manage and determined by company’s capability of managing any financial crisis. This is because all loans are always tied to the requirements that are laid down by the working capitals. Working capital is always determined by taking into account the difference between total assets and total current liabilities. Another important financial ratio analysis tool that helps in solving the financial problems in the financial statement is the leverage ratio or debt/worth that gives the information that the company or business is able to meet its financial debts obligations (Frazer, 2001) It is the care taker of creditor money versus owner’s equity. This is always the ratio of total liability and the net worth. The higher the leverage ratio, the more vulnerable and risky is the business, where a creditor will view this business as less credit worthy. In the financial statement it is always possible to extract information that can generate income statement ratio analysis that enables business profitability. These ratios include the use of gross margin ratio that is fundamentally important in determining the percentages that arise from sales dollars that is derived by getting the difference between the cost of goods sold and net sales. By incorporating these ratios, it is always critical for businesses to measure the percentage of sales dollars remaining so that the overhead expenses of the business can be paid (Drake, 2006). Moreover, it helps in getting the business strength and weaknesses. This ratio is derived by getting the ratio between gross profit and net sales. The other important financial ratio analysis of the financial statement is the use of net profit margin ratio; this is the difference between the cost of goods sold and all expenses without including income taxes. It gives an insight into other businesses by taking into consideration the return on the sales of other competitors in this industry. It is readily calculated when the income tax is not yet included so as to take into account the fact that the tax rates and tax liabilities do differ from one business to the other (Frazer, 2001). This ratio is arrived into by getting the relationship between the net profit before tax and net sales. Other theories and ratio practices that are involved in scrutinizing the financial statement is management ratios that helps in configuring the relationship between the balance sheet and the statement of the income information. The use of inventory ratio in the analysis of financial statements depends on how that particular inventory is managed so as to realize business profitability. The inventory turnover is realized by considering the ratio of net sales and average inventory at cost. Another important financial ratio analysis tool that is used in getting important information for well operated businesses is the use of accounts receivable turnover ratio that helps in determining how well accounts receivables are collected and managed. Use of this tool always informs the management and enables them to be focused on the strategies of having the collection policy in place (Drake, 2006). If in any case the amount of receivables converts slowly into cash, then it is a clear indicator of serious impairment of liquidity. This process involves getting the ratio of net credit sales per year and the total number of days in a financial year which is 365 days so as to get daily credit sales. The final accounts receivable turnover in days is therefore found by getting the ratio of accounts and daily credit sales. (Moles 2011) Use of return assets ratio in the analysis of financial statements helps in determining the efficient ways of generating profit in a business by employing the assets so as have a good comparison by using the ratios from other companies. This ratio is derived by getting the comparison between the net profit and the amount of the total assets (Frazer, 2001). The final tool that can be used in analyzing the financial statements is the return on investment ratio which is considered as the most fundamental one since it helps in getting the percentage of the returns in the funds invested in the company by the company owners. This is the only way that the investors in a particular company can be able to know the significance of their investment and the worth of their money (Drake, 2006). If the value of the return on investment ratio is by any means less than that of the alternative return then it is not important taking it seriously. Also it gives some sense in the saving accounts as the saving instruments. It is found by getting the ratio of net profit tax and the net worth. It also helps in getting the business trend so as to compare the progress with the performance of others business statements’. (Fraser & Ormiston 2001) Conclusion In a nut shell the importance of ratio analysis in financial management can never be assumed by any investor or manager who intends to succeed. Ratio analysis presents one of the best ways of understanding how the company is doing and the projections which can be made. An investor can only be in a position to buy the stock from the company after critically looking at the ratios in the company. The continued developments in various concepts in ratio are as a result of interest business people have in the ratios. REFERENCES Anthony, R. N., & Breitner, L. P. (2003). Core concepts of accounting (8th ed.). Upper Saddle River, NJ: Prentice Hall Drake, P., & Fabozzi, F. J. (2006). Analysis of financial statements (2nd ed.). Hoboken, N.J.: Wiley ;. Fraser, L. M., & Ormiston, A. (2001). Understanding financial statements (6th ed.). Upper Saddle River, N.J.: Prentice Hall. Lootsma, F. A. (1999). Multi-criteria decision analysis via ratio and difference judgement. Boston: Kluwer Moles, P., Parrino, R., & Kidwell, D. s. (2011). corporate finace. newyork: john wiley & sons. Parrino, R., & Kidwell, D. S. (2009). Fundamentals of Corporate Finance. New York: John Wiey and Sons. Siegel, J. G. (2009). Schaums Outline of Financial Management, Third Edition. New York: McGraw-Hill. Read More