The Extensive Use of Financial Ratios by Practitioners and Researchers - Essay Example

?INTRODUCTION Financial ratios are extensively used by financial analysts, auditors, investors, shareholders, researchers, practitioners and management of the organizations to evaluate and identify different factors, trends and performance of the company. Financial ratios are also used to evaluate the current performance of the company against its past performances as well as performance of competitors and overall industry. According to Lev and Sunder (1979) the extensive use of financial ratios by both practitioners and researchers is often motivated by tradition and convenience rather than resulting from theoretical considerations or from a careful statistical analysis. However, this statement of Lev and Sunder have gained criticism as well as praised by different scholars and analysts as in their research Lev and Sunder were able to identify different issues of using financial ratios. One of the major reasons for using financial ratios is to compare different firms in the same industry regardless of the size of the organizations. For instance, Return on Equity (ROE) can be calculated by using two variables; profitability or income of the organization and its equity therefore even if the size of the firms differs a lot but still these two firms can be compared to each other (Gowthorpe, 2006). As a result, financial ratios are helpful in controlling different factors while comparing different companies operating in the industry and allowing researchers a platform to compare firms which might have not been possible without these ratios. Similarly, besides controlling the size of the organization, financial ratios control other factors like technology and assuming that these factors are uniform within the same industry. So, with these important considerations being assumed similar or ignored by the users of financial ratios it is significant to consider several important or concerns which are raised by financial ratios: Financial ratios ignore size of the organization therefore a firm which has a more capital is able to invest more and thus it could get a better return on its investment Technology of the firm is ignored and other important variables that might affect the performance of the organization like economies of scale. Riskiness of the firm is ignored, as investors investing in a riskier firm would like to demand higher return on investment therefore the firm should earn higher returns in order to attract investors Therefore all this considerations or limitations of financial ratios have raised concerns on important issues that are ignored by the financial ratios but despite of this fact, financial analysts, researchers and practitioners have been continuously using financial ratios. ADVANTAGES AND APPLICATION OF USING FINANCIAL RATIOS There are several advantages and applications of using financial ratios which are as follows: ENABLES COMPARISON BETWEEN DIFFERENT FIRMS Financial ratios are helpful in allowing comparison between different firms and their performance and therefore management of the firm is able to take decisions considering its competitors in the industry and overall averages in the industry (Bodie, Kane, & Marcus, 2004) BENCHMARKING TECHNIQUE Because of financial ratios, companies are able to set their performance targets and measures against the leading firms in the industry and as they aim high, they are able to improve their overall performances (Heaton, 2002). FINANCIAL RATIOS ENABLE ORGANIZATIONS TO EVALUATE FROM THEIR PAST PERFORMANCES Financial ratios allow organizations to compare their past performances against their current performance and in this way they are able to identify whether they are going in the right direction or not (Correia, Flynn, Uliana, & Wormald, 2007). FINANCIAL RATIOS ARE HELPFUL IN IDENTIFY DIFFERENT COSTS AND EXPENSES THAT CAN BE REDUCED With the help of financial ratios, management is able to identify different costs and expenses of the company that have increased over the last few years or costs and expenses in comparison to their competitors and therefore management can take steps to accordingly to improve its profitability. PROBLEMS WITH USING OF FINANCIAL RATIOS Different financial analysts have presented several problems regarding using of financial ratios as a mean to analyse and compare the performance and profitability of the organisations in the industry. It is perceived that financial ratios ignore some of the relevant factors which directly impact the profitability of the organisation for example inflation. Some of these issues are as follow: NEGATIVE NUMBERS AND CONTROL FOR SIZE It becomes difficult to measure and analyse the financial ratios if one or both variables are negative. It becomes difficult to calculate and interpret the relative change in the ratios and thus in the performance of the organisation. For instance, when denominator or numerator takes negative value, the partial derivate with respect to the other value also change and thus it becomes difficult to calculate the relative change with the help of calculus. It is evident that the change of sign by any variable will depict the change in the favourable condition. For instance if the earnings of the organisation change from being positive to negative, this means that the profitability of the organisation has reduced. But on the contrary the relative change in the earnings to ratio will be positive, which will depict that the firm has increased its profitability. Hence, it is difficult to interpret and analyse the relative performance of the organisation with the help of financial ratios because of the negative numbers (Porter, & Norton, 2011). HIGHER PRODUCTIVITY OR PERFORMANCE MIGHT BE BECAUSE OF LARGER SIZE OF THE FIRM: There is very high possibility that the higher productivity or performance of the organisation is because of the larger size of the organisation. The financial ratios ignore the size of the firm while comparing it with the industry average. It is very much possible that a particular organisation showing high production and profitability has higher capacity as compared to other organisations in the same industry. It is difficult and inappropriate to compare the organisations of different sizes on the basis of the average financial ratios for that particular industry. The larger organisations have higher working capital and can thus allocate and use more budget for marketing and other related activities, which in turn would increase the sales of the organisation (Lewellen, 2004). Therefore higher profitability of the organisation can be because of the large size, higher working capital, or higher marketing expense. Marketing expense is directly related to the increasing sales and revenues (Van Horne, 2007). Hence, in order to get an accurate view of the performance and profitability of the organisation it is important to consider all these factors. HIGHER PROFITABILITY COULD BE BECAUSE OF IMPROVEMENTS IN TECHNOLOGY The financial ratios also ignore or neglect the factor of advancement in technology. Organisations which are focusing more on new innovations and technology advancements are able to generate more positive financial results and thus have good financial ratios. However, this factor is not incorporated in the calculation and analysis of the financial ratios. OTHER MODELS FOR EVALUATING FINANCIAL PERFORMANCE Considering the issues of financial ratios, there have been several methods suggested by different analysts to evaluate and compare firms in the industry and some of these methods and models include economic value added, cash value added, shareholder value and many claim that these methods are able to measure the performance in a better way. Also these measures are helpful for the management and users to take important decisions and actions by analysing these models. Among these models, economic value added has been one of the most renowned models as it considers the end profit of the firm after its cost of capital. Though, this model is not a good one as it is not able to generate better understandings as compared to the existing comprehension of the other measures associated with performance (Hamadi & Awdeh, 2011). Several other models like Residual Income models (RI), the Economic Profit model (EP), and the Discounted Cash Flow model (DCF) have also been used by practitioners to compare and evaluate performance of different companies in the industry except DCF which is used more for the valuation purposes. CONCLUSION Practitioners and researchers have been motivated to use financial ratios because of its convenience and because financial ratios are used by firms for years and they do not want to change the way in evaluating firms in the industry and come up with more techniques because these financial ratios have been used across the world and their results have been satisfactory so far despite of some of the loopholes and limitations present in the financial ratios and in their implications. However, with the passage of time as more issues have been raised regarding financial ratios and their applicability for firms within an industry researchers have started and come up with several new models that are helpful in evaluating and comparing firms within the industry and these models have been able to provide better measures than financial ratios. Therefore currently researchers and practitioners use financial ratios as well as other models and then take decisions by carefully analysing the situation from different aspects. References Bodie, Z, Kane, A, & Marcus, A 2004, Essentials of Investments, McGraw-Hill: New York. Brigham, E, & Ehrhardt, M 2010, Financial Management: Theory and Practice,13th edition. South-Western Publisher: USA. Correia, C, Flynn, D, Uliana, E, & Wormald, M 2007, Financial Management. Juta & Co. Ltd., Cape Town. Gowthorpe, C 2006, CIMA learning system 2007 Financial analysis. Elsevier Ltd, Oxford, UK. Hamadi, H, & Awdeh, A 2011, ‘Determining Financial Performance: Evidence from UK and USA Firms’, International Research Journal of Finance and Economics. Available at < http://www.eurojournals.com/IRJFE_72_11.pdf> [Accessed 8 December 2011] Heaton, J 2002, ‘Managerial Optimism and Corporate Finance’, Financial Management, vol. 31, no. 2, pp. 33-45. Lev, B, & Sunder, S 1979, ‘Methodological issues in the use of financial ratios’, Journal of Accounting and Economics, vol. 1, no. 3, pp. 187 – 210. Lewellen, J 2004, ‘Predicting Return with Financial ratios’, Journal of Financial Economics, vol. 74, no. 2, pp. 209-235. Porter, G, & Norton, C 2011, Financial Accounting: the impact on decision makers. South-Western Cengage Learning, Mason, OH Van Horne, C 2007, Financial Management & Policy, Pearson: London. Read More