Ratio Analysis Usefulness and Limitations - Essay Example

of project: RATIO ANALYSIS USEFULNESS AND LIMITATIONS and number: submitted: BasicConcept The effective performance of any company and the continuous room of improvements in their performance can be critically seen and analyzed through its latest financial statements. Majority of the stakeholders of any Company always do have keen interest and attachments towards the latest financial results of such company. But most of them, do find it difficult to cope up with such a large numbers and figures presented in the Company’s financial statements and information and thus, finds alternatives mean in order to prevent themselves from such a huge bunch of figures and at the same time do have a proper, brief and critical evaluation of such Company’s attest financial results. Therefore, a technique of ratio analysis was introduced by some experts and financial analyst, which perfectly meets the core requirements of these stakeholders at large. Definition Ratio analysis can be simply defined as the quantities analysis of various aspects of the entity through the financial information presented or displayed onto the face of its financial statements (Chu et al., 2002). This analysis can take different facets like the analysis of operational performance of the entity, its investments performance, its liquidity analysis, its gearing evaluation and so on. Furthermore, ratio analysis mostly based its evaluation on the major line items presented in the financial statements like the income statement, balance sheet, and cash flow statement, in particular; the ratios of one of such line item or a combination of those items, to another item or combinations are then thoroughly calculated and analyzed (Loth, 2014). Most importantly, Ratio analysis is specifically utilized in the evaluation of distinct performance aspects of any business that can be break down into the aspects like, company’s operating and its financial performance such as its effectiveness, efficiency, profitability, liquidity, investing capabilities and solvency (Moyer, 2006). Hence, the ratio analysis serves as the yardstick in order to comprehend the stakeholders of business that whether the performance of such business is improving over the time or it is deteriorating. In addition, these ratios also facilitate the investors of the Company, its stakeholders or potential investors to compare the performance of the Company across different entities in the same industry or related industry in the same sector. And with the help of such analysis, the stakeholders of the Company would probably get an idea of comparative analysis and valuations between intercompany financial evaluations and thus, ratio analysis acts as a cornerstone for such fundamental analysis of Companies itself and between various Companies operating in a similar industries or sectors. Usefulness of Ratio Analysis There are significant numbers of usefulness or benefits that are widely associated with the technique of ratio analysis in order to critically analyze the performance of any sort of Company for its different nature of financial information. Hence, some of the major usefulness of ratio analysis have been discussed as under, giving due regard to the organization I have been reference to, i.e. Sainsbury; The most important and substantial usefulness that the ratio analysis offers to its users is the simplicity in the presentation and interpretation of the huge chunk of financial information and data contained in the financial statements of the Company. Hence, the user, investors or potential investor f the Company has just to make reference and visualize the certain figures and financial highlights resented via ratio analysis as compare to reviewing the complete financial information contained in the Company’s financial statements (Brigham & Ehrhardt, 2008). It helps in performing trend analysis of the financial information of same company over distinct number of periods of its operations. For example sales figures can be compared for past 3 to 5 years of any company and then, using such comparisons in order to calculate gross profit, operating profit and net profit ratios, to analyze the overall operating performance of any Company. As in the case of Sainsbury, its Sales figure has been improved from 2012 to 2013 by 1 million pounds, but however, its Gross profit, operating profit and net profit is not significantly improved, because of increase of expense in cost of sales head, administrative expenses, and finance cost. However, there has been some decreased in tax expense for the year in 2013, but that reduction, does not impact the profit improvements to a much greater extent. Ratio analysis dynamically helps in making effective decisions in future; therefore, it enhances the ability of decision making of an investor of a Company. As the data presented in the Company’s financial information is raw one, and only ratio analysis can make it presentable and useful by making them compact in some bunch of ratios, like current ratios, GP ratios, gearing ratios, Acid ratio, EPS, PE ratio and many more. As it can be witnessed from the latest annual report of Sainsbury for the year of 2013, the report contains approximately 135 pages, which includes a lot of information about the company, its competitors, suppliers, future prospects and many more, but the only helpful information for the investors would be the thorough analysis of some useful and key ratios of the Company in order to make future decision about their investment in the Company. Ratio analysis also helps in making the insight of financial forecasting and planning of a company. For instance, every year we calculate some of the ratios consistently in order to observe the changing scenario from each year to the next one and When we make such trend analysis of open or couple of these ratios, then we can surely get the useful information and insight for our future predictability, forecasting and planning of any Company (Kumar, 2011). Ratio analysis also facilitates in various controlling and monitoring aspects of the business, in a way that we can simply create the standard or minimal of performance levels for each and every line items of financial statement including balance sheet and the statement of profit and loss. For example, the management of Company can clearly set standards for its sales team in coming quarterly results of the Company, which could say that such figure of sales are expected from each of its sale team employees. Solvency and investing capabilities of company can be analyzed in depth manner with the help of ratio analysis as long term solvency ratios and gearing ratios would be calculated and evaluated by potential investor of the Company before investing any cash flow into the shares, stocks or securities of the Company. Further, creditors are represented as the most core business element s for any company involved in the manufacturing, trading and retailing business. The creditors would be interested to know as to how soon their current trade debts would be repaid by the management of the Company and the consistency of such payments. This could be clearly analyzed with the help of creditor’s payment period ratio (Small Business - Chron.com, 2014). As in the case of Sainsbury, he Company has maintained its creditors payment ratio by same number of figures and payment periods as displayed from its current financial statements. The figures of its current liabilities have almost been consistent in the year 2012 and 2013. Lastly, ratio analysis broadly helps the investor and other stakeholders of the Company in analyzing its various line items and performances comparison with its competitors in the same industry, its stock valuations, liquidity analysis, and investing capabilities of a Company. Limitations of ratio analysis However, with the dynamic number of advantages and usefulness’s of ratio analysis for various stakeholders of the businesses, there are certain limitations and shortcoming also associated with the ratio analysis techniques, which have been discussed as under; Different companies generally operate in distinct industries or sectors and each of such industries do have different environmental atmospheres and conditions under which they specifically operates or functions, such as regulation, competitors, legal framework, market structure, etc. Thus, such varied factors from one industry to the other one, are so significant and impactful in essence that a realistic financial and operational comparison of two or more companies from different sectors or industries might be misleading to the users. Financial accounting data and information is highly based and affected on various estimates and assumptions made by the management of the Company for the preparation of its financial statements. Further, Accounting standards also allow different room for accounting policies and assumptions as well, which substantially impairs the comparability of tow companies in particular and hence, ratio analysis technique would be less effective in such cases. Further, ratio analysis techniques are highly based on the current and past relationships of various operational and financial aspects and performance of any entity, however, the users are most concerned in order to obtain and analyze future information about the Company in most cases. Ratio analysis only gives the detail and analysis about the numbers and figures involved in the financial statements of the Company, but it fails to generate and provides you the information about the basic cause of such numbers or figures being generated within that particular Company (Peavler, 2014). References or Bibliographies Chu, N. C., Taylor, R. N., Chavagnac, V., Nesbitt, R. W., Boella, R. M., Milton, J. A., ... & Burton, K. (2002). Hf isotope ratio analysis using multi-collector inductively coupled plasma mass spectrometry: an evaluation of isobaric interference corrections. Journal of Analytical Atomic Spectrometry, 17(12), 1567-1574. Loth, R. (2014). Financial Ratio Tutorial | Investopedia. [online] Investopedia. Available at: http://www.investopedia.com/university/ratios/ [Accessed 7 May. 2014]. Moyer, R. C., McGuigan, J. R., & Kretlow, W. J. (2006). Contemporary financial management. Mason, Ohio: Thomson/South-Western. Brigham, E. F., & Ehrhardt, M. C. (2008). Financial management: Theory and practice. Mason, Ohio [u.a.: Thomson. Kumar, V. (2011). Advantages of Ratio Analysis. [online] Svtuition.org. Available at: http://www.svtuition.org/2011/12/advantages-of-ratio-analysis.html [Accessed 7 May. 2014]. Small Business - Chron.com, (2014). The Advantages of Financial Ratios. [online] Available at: http://smallbusiness.chron.com/advantages-financial-ratios-3973.html [Accessed 7 May. 2014]. Peavler, R. (2014). Limitations of Financial Ratio Analysis. [online] About.com Business Finance. Available at: http://bizfinance.about.com/od/financialratios/tp/limitations-financial-ratio-analysis.htm [Accessed 7 May. 2014]. Read More