Financial Ratios and Financial Analysis
Topic: Discuss the purpose and importance of financial ratios and financial analysis. What are the limitations of financial ratio analysis? If we divided the users of financial ratios, such as short-term lenders, long-term lenders, and stockholders, which ratios would each prefer and why? Provide examples.
The writing assignment will demonstrate writing across the curriculum by responding to the following topic in a 750 – 1250 words (3 – 5 pages of content/body) paper. Your paper must integrate at least three external references. Your paper must be formatted according to APA 7th edition.
Sample Answer
Financial Ratios and Financial Analysis
Financial ratios are arithmetic tools used to analyze and compare financial relationships between items on income statements, balance sheets, and cash flow statements. On the other hand, financial analysis involves the use of data generated from the financial ratios to develop helpful insights into a company’s productivity, solvency, effectiveness, liquidity, and coverage (Ullah, 2021). There are different types of financial ratios utilized in financial analysis. They include working capital ratio and cash ratio, which provide valuable insights regarding a company’s liquidity or the ability of the company to acheive its current debt obligations using its existing assets (Ullah, 2021). This essay discusses the purpose, importance, and limitations of financial ratios and financial analysis.
Financial ratios and financial analysis are done for various specific purposes. One of them is to extract information about its performance from its financial statements (Nadar & Wadhwa, 2019). Secondly, financial ratios and financial analysis guide entrepreneurs when developing business plans and making presentations for creditors and investors. The information generated from the financial ratio analysis help entrepreneurs to set time-bound performance goals in terms. Also, the information obtained from the financial analysis is crucial for implementing strategic change within an organization (Nadar & Wadhwa, 2019). Thirdly, a firm conducts a financial analysis to identify the strengths and weaknesses of a company. This information is crucial for investors since it allows them to determine the relative strength of companies, regarding its capacity to invest. Fourthly, financial ratio analysis is also done to reveal trends in particular industries. This information helps entrepreneurs or company management measure a company’s performance against all industry players (Nadar & Wadhwa, 2019). Lastly, financial ratios and financial analysis provide crucial data for comparison against firms and their specific industries. Financial ratios position all organizations on a relatively equal playing ground. Thus, financial ratios serve as standardized approach used to compare firms and industries.
Financial ratio analysis and financial analysis are crucial in a business or company. One of the benefits of financial ratios is that they allow a company to improve its performance (Nadar & Wadhwa, 2019). Financial ratios enable entrepreneurs to determine the connection between two or more elements of financial statements. They are applied more effectively when outcomes over different periods are weighed against each other, thus, offering entrepreneurs an opportunity to follow a firm’s performance over time and discover various indications of trouble. Liquidity ratios are an example of financial ratios that measure a firm’s financial health. They help inform the entrepreneur and other company stakeholders such as lenders and suppliers regarding the ability of a company to clear its current obligations using its existing assets (Kadim et al., 2020). They include quick ratio and working capital ratio. Another benefit of financial ratio analysis is that it allows a company to set goals for high performance. Since financial ratios compare components in financial statements over time, they can help financial and business managers determine a rational performance for the company by assessing its performance over a given period and even comparing its performance with a leading company to set goals for high performance (Nadar & Wadhwa, 2019). In addition, financial ratios and financial analysis provide essential information that helps companies manage their debts effectively (Kadim et al., 2020). Management of obligations is a priority for any business that wants to achieve sustainable development. For instance, financial ratios, such as the current ratio, reflect how a company can effectively meet its upcoming debts using its existing assets. With this information, a company’s management can develop effective strategies that can help it manage its obligations effectively to enhance business sustainability. Lastly, financial ratio analysis plays a vital role in reducing risk exposure. It achieves this by identifying inefficiencies and errors in a company’s financial process and predicting changes in market conditions. Thus, with this information, the company sets various effective measures to mitigate the expected risks, hence enhancing its financial health (Nadar & Wadhwa, 2019).
Despite the above benefits, financial ratio analysis has diverse limitations. One of them is that financial ratio analysis fails to consider external factors affecting a company’s financial performance. For instance, financial ratios do not consider the changes in the economic cycle, taxation policies, climatic conditions, and even government policies (Faello, 2018). Besides, these changes affect every company inappropriately. In that regard, it can seem irrational for a company to focus on financial analysis in making its decisions exclusively. The other limitation of financial ratio analysis is that it only generates numbers and does not give the contributing factors (Faello, 2018). Therefore, they are insignificant without comparison against trend data or industry data. After making the comparison, it is easy to find the cause of the numbers generated. Thirdly, financial ratios depend entirely on the data found in a company’s financial statements. Some companies use window dressing to manipulate the data expressed by their financial statements to look better (Faello, 2018). This can undermine the reliability of financial ratio analysis. Fourthly, financial ratio analysis ignores the aspect of inflation (Faello, 2018). Many financial ratios are calculated using historical costs. In that regard, many ratios fail to consider changes in price level between given periods. Therefore, this limits the ability of the information generated from financial ratio analysis to reflect a company’s correct financial situation. Another limitation is that financial ratios have no standard definitions. As a result, firms may be utilizing dissimilar formulas for the ratios (Faello, 2018). The current ratio is an example of a financial ratio applied differently in companies. Some companies accounts all current liabilities while others do not include bank overdrafts from current liabilities when computing the current ratio.
Short-term lenders prefer liquidity ratios such as the current ratio. This type of financial ratio helps inform short-term lenders of the capacity of the company to meet its obligations using its existing assets (Ullah, 2021). Therefore, these users prefer a high current ratio. This shows that the company is able to clear their obligations using its current assets. Long-term lenders would choose solvency ratios, such as debt and debt-to-equity ratios. These financial ratios inform a company’s ability to meet its long-term obligations (Ullah, 2021). Besides, stockholders would prefer profitability ratios because they are concerned about the returns from their investment in the company. For instance, return ratios will help them whether a company is making a profit or a loss to increase or reduce their investment in the company, respectively (Ullah, 2021).
Financial ratios are prepared in a business organization to analyze its financial position, assess its financial performance, and aid in decision making. The information generated from financial ratio analysis helps the development of effective financial strategies that help enhance a company’s financial performance, reduce its risk exposure, and improve its overall performance. However, financial ratio analysis has various limitations which affect its application in a company. For instance, the financial ratio does not consider the external factors affecting the company’s financial statements, such as inflation and change government policies.
