FINANCIAL RATIOS

Financial ratios help managers evaluate their company’s performance and compare it against similar businesses in the same industry.

Uses of Ratio Analysis

Not just managers, all users of financial statements use the financial ratios for their decision-making. For example, employees can use the ratios to the margin of personnel expenses against revenue.

Though the evaluations are not real-time, it allows you to follow the company’s performance over time and analyse the trends, it could be to strengthen the company’s weaknesses or identify and improve on its shortfalls.

Comparisons

One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the industry to understand the company’s position in the market.

Financial ratios, such as P: E ratios, can be obtained from other competitors and compared to the company’s ratios. This can help management identify market gaps and examine its competitive advantages, strengths, and weaknesses.

Which can then be used to formulate decisions that aim to improve the company’s position in the market.

Trend line

Companies can also use ratios to see if there is a trend in financial performance. Established companies collect data from the financial statements over many reporting periods.

The trend obtained can be used to predict the direction of future financial performance, and identify any expected financial turbulence, that would not be possible to predict using ratios for a single reporting period.

Word of warning, it is cumbersome as single-year analysis can be easy, but multiple years comparison is complex.

Operational efficiency

The management of a company can also use financial ratio analysis to

determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to determine if the financial resources are over-or under-utilized.

The issue here is that using an average won’t give an accurate analysis especially when one or more of the reporting periods has an outlier or is skewed.

Whichever way, the financial ratio and its analysis are important to financial statement users, especially its managers.

ADVANTAGES OF FINANCIAL RATIOS

The advantages of financial ratios include:

1.  It is a standardized method of comparison and analysing financial statements and their performance against the industry benchmark.

2.  It helps with the company planning and performance for the future by forecasting.

3.  Helps in identifying the business risk and analysing it, especially if it is peculiar to its industry.

DISADVANTAGES OF FINANCIAL RATIOS

1.  Inflation is not taken into cognisance when preparing the financial statement.

2.  The financial statements being analysed are not in real-time. Since they’re historical, the values of assets and liabilities are expected to change over time.

3.  Though it is expected that most companies in an industry have the same reporting style, some do not may be due to country of origin. Thus, some financial statements might not be comparable.

4.  Also the financial statements might be reporting wrong figures or not being verified, so their accuracy is in question.