Financial ratios enable different stakeholders in the sector to substantially predict a company’s future performance using several data sources presented. The business management and investor benefit in different ways from the regulators, financial analyst, or the prospective investors. the ratios are as verse as those who need them.
In my opinion, the financial ratios in themselves tell only single stories. I believe that the limitations are such that they require additional data to validate them. But they are a starting point for further investigation. Often there are qualitative data that need to be interrogated to understand those figures.
In the case study published by IBS Research Centre titled “Is Apple Managing its 4 P’s Effectively?”, the author pointed out that “In 2006, analysts agreed that…. Apple was not very good at deploying capital”, simply because its return on equity was 2% compared to a competitor like Microsoft with a return on equity of 27%. At face value this argument makes a whole lot of sense. However, ROE’s can be deceiving if a company has recently taken out a lot of debt. It’s important to view Return on Equity alongside other indicators and metrics. Perhaps, if we interrogate and deeply query the Company’s strategy and philosophy, we may begin to understand that this may not fall under the case of capability, which the analysts implied. What says the equity owners are not happy with the status quo?
In our last intensive week for the 1st Semester of the MBA program, we took a project called the Capstone Project for the corporate financial accounting. Every Corporate Financial Accounting student takes this project. It entails understanding, analysing, and reporting one company’s financial statements for a ten-year period and benchmarking it with another company in the same sector. My group worked on a Paint manufacturing company (let us all it X) that has been in Nigeria for more than 60 years. Our studies covered the period between 2013 to 2022.
I observed a relationship between company X’s policy direction, history and strategy to the performance measure as indicated in the financial ratios. This company, which used to be among the best paint brand in the 1970’s and 1980’s, has changed ownership thrice since its incorporation. It was overburdened by debt for most of the period we studied and at some point, had to sell off some of its properties to pay debt. On the other hand, the benchmarked company (we call it Z) which is twice the size of company X in capitalization, has had a relatively smooth operation, low expenses, higher sales, consistent and predictable net profit.
Ironically, Company X presents a better performance in liquidity especially from the period when they sold their assets to clear their debts. Before then there was no consistent trend because. Sometimes, it was below industry threshold, other times it went above. But the benchmarked company was consistently hovering around industry average for the entire duration. Ordinarily, a positive Current and/or Quick ratio should appeal to a lender. However, as lender I will be less comfortable to with Company X, even if it has shown a higher Liquidity ratio in recent years.
Financial ratios make the numbers on financial reports standardized and reveal aspects like profitability, solvency, leverage, and turnover. For analysts and those charged with making decisions with these numbers, these ratios should be a starting point. The limitations of financial ratios are that they are of past performance and may not tell the whole picture. The numbers may also be manipulated to achieve an outlook and not reflect the true nature of the business. Without lying a business can project the image they want the stakeholders to see. Corporate Finance Institute encourages analysts to be “aware of these possible manipulations and always complete extensive due diligence before reaching any conclusions”.
#memba12 #lbs
