Inadequacies of Accounting Ratios as Tools of Financial Analysis - Essay Example

Inadequacies of Accounting Ratios as Tools of Financial Analysis First of all, in terms of accounting and related sciences we need to outline what exactly the term that defines the financial ratios is. This indeed is the ratio comprising of two numbers that are present in the different flows of a company or at distinct reported levels within it. It can also be adjudged as the basis for the two financial flows categories which are in essence present due to the division of each other which involves profit margin as well as the entity related with profit or revenue as one might put it in the first place. More importantly, financial ratios are there due to the level that is divided by a financial flow itself which could be in the form of price or in simple plain accounting practices, the earnings. On the contrary, the financial ratios are also possible due to the flow that goes on to divide the same by a level that comprises of the return on equity or the earnings itself with respect to the equity. [Osteryoung, 1992] In calculating financial ratios, one must fathom that the numerator or the denominator at any point in time might just be the ratio, remarked as the PEG ratio. This paper discusses the financial ratios and the five categories associated with it as well as the questions that are answered to decide how the weight is evaluated owing to the financial health of an entity. This is quite true that in terms of financial ratios, the ratio analysis has got its due part in telling one and all about the whole category and as such the industry. On the other hand, there are a number of important pointers that one can pick with regards to the theory of ratios for that matter. Let us start with the financial ratios. These are the flags that in essence lay the foundation for showing those areas that can be remarked as the ones having strengths or weaknesses. [Mills, 1998] For this point in case, even more than one ratios can eventually be quite misleading, but when the same are combined with different knowledge that are available in the wake of an industry, ratio analysis can go a long way in discussing and indeed detailing about this industry. Secondly, one is unable to discern or find a single correct value for a ratio that needs to be chalked up for this whole scenario and more often than not; these are not absolute terms that are devised as a result. Similarly, the observation that holds the ground for the value of a particular ratio as being too high, too low or just in between actually relies heavily on the viewpoint with which this analyst is putting it. It needs to be thus seen with his eye and vision and cannot be generalized as a result. Another question that crops up here is that how a financial ratio is deemed as being consequential merely when it is compared with some standard such as another industry trend, ratio trend or a ratio trend which is there specifically for the industry that is going through the process of complete analysis and checking. [Khoury, 1990] The answer to the same is that in the case of trend analysis, industry ratios are compared over time which might last for even years as a result. For doing the same, year-to-year comparisons can just be the right norm and thus show the way for the action that has to be taken in the wake of the analysis of financial ratios. However for best results, it is advisable that the trend analysis is made for a period of five years and nothing less should be allowed to ensure smooth working and better results. Another form of ratio analysis is that of the cross-sectional analysis which essentially does its bit in comparing a firm’s financial ratios in relation with the industry ratio averages. It also has a more renowned sub entity in the form of a cross-sectional analysis that puts both the financial ratios of two or more companies which are pretty much in similar lines of business and then compares them ultimately. In terms of the five categories of financial ratios that are very important one could question the manner in which decisions can be sorted out so as to weigh in the financial ratios in evaluating the financial condition and prosperity levels of an entity or organization for that matter. These five categories are comprised of the liquidity ratios, leverage capital structure ratios, profitability ratios, turnover ratios and last but not the least capital market ratios. The questions that could be asked in the wake of the liquidity ratios comprise of whether a firm is able to meet its short term financial obligations whenever they are on time or fall due with a particular time frame. In such a case, two liquidity ratios are most helpful. One of these includes the current ratio which entails the use of currents assets that are divisible by the current liabilities and the second one talks about the quick or acid test ratio where the current assets minus the inventories are divided by current liabilities. The leverage capital structure ratios question for the indication limits as to whether or not the firm has the ability to fulfill its long term commitments that it owes towards the debt holders. For this, the debt to equity analysis ratio is made use of which focuses on the total liabilities that are divided by total shareholders’ equity. The third category within financial rations emphasizes its attention on the profitability ratios and questions the level of profits that are put out or generated by the company over a period of time. For this, the company has to look forward to three different profitability analysis ratios that include return on assets ratio where net income is divided by the total assets. The second sub part in the wake of an entity is that of the return on equity ratio where the net income is divided by total shareholders’ equity and lastly, the net profit margin where the net income is divisible by sales. The penultimate category is that of the turnover ratios within the financial ratios and it questions the efficiency of the company whilst its using up of the different assets that it has over a period of time. Indeed this is the most useful of the lot. In this, one has to see that a ratio uses another ratio in order to come to an end result. The asset turnover ratio is calculated via the sales that are divided by average total assets. The capital market ratios form up as the last category of financial ratios whereby the question for a firm can be focused on the indication of a company’s ability to whether it can win the confidence of the stock market at a particular juncture of time or not. In this, the most significant ratio is that of the price earnings analysis ratio where this ratio makes use of another ratio. The earnings per share are calculated as the net income that is divided by number of common shares which are to date outstanding. The price earnings ratio is the market price of common share which is divided by earnings per share. In Text Citations Osteryoung, Jerome 1992 ‘Financial Ratios In Large Public And Small Private Firms’ Journal of Small Business Management Vol. 30 Mills, John R 1998 ‘The Power Of Cash Flow Ratios’ Journal of Accountancy Vol. 186 Khoury, Sarkis J 1990 ‘The Deregulation Of The World Financial Markets: Myths, Realities, And Impact’ Quorum Books Word Count: 1,226 Read More