Ratio analysis is a quantitative method used to analyze the company’s data contained in financial statements. This analytical information helps to understand company’s profitability, solvency, efficiency, liquidity, and market value.
These financial ratios are used to develop relationships between individual accounts on financial statements like equity, debt, cash, income, etc. The independent items on financial statements are not sufficient to analyze a firm’s status. A relation between these items and comparisons with other players makes this information more meaningful. Therefore a ratio analysis serves the purpose of financial analysis and financial management.
Ratio analysis also helps a firm to compare its current year’s performance with the previous year’s performance to identify areas of improvement and best achievements. Firms can also compare performance with other competitors to learn about their position in the market. Hence, ratio analysis is a great way to improve a firm’s performance and profitability by making effective future decisions based on analyses of a firm’s or its competitors’ data.
Objectives of Ratio Analysis
1-Simplify accounting information
It would have been an inaccurate and time-taking procedure if the debt of one firm would have been compared to the debt of a competitor firm in order to know which one is lesser. Here a debt-to-equity ratio of one firm can be compared with the debt-to-equity ratio of another reflecting which company has greater shareholder’s equity to pay off outstanding debt.
The liquidity ratios, including quick ratio and current ratio, determine if a firm has sufficient assets to cover its short-term and long-term debt and other obligations.
3-Assess operating efficiency
Activity ratios like inventory turnover of total asset turnover, are used to analyze a firm’s ability to run its operations efficiently and utilize its resources wisely.
4-Analyze the firm’s profitability and performance
The profitability and performance of a firm are indicated by ratios like return-on-equity, return-on-debt, gross profit margin, net profit margin, etc. By calculating all these the management can evaluate if the company’s goals in terms of profit, satisfied customers, market share etc were met or not. Later on, suggestions and measures can be taken to remedify the problems.
5-Allows intra-firm and inter-firm comparisons
The management can use a comparative analysis to track the firm’s progress over time. Additionally, comparisons with competitors would allow a firm to improve its performance according to market standards.
6-Helps in forecasting, planning, budget estimation
By carrying out a trend analysis using financial ratios a firm can perform better forecasting and planning. Ratio analysis also helps in budget estimation.
Limitations of Ratio Analysis
Following are some of the limitations for ratio analysis.
1- Ratio analysis is based on historic data
Usually, ratio analysis is conducted on historical data. Though comparisons of previous financial information might help in highlighting areas of success and failures but it is not sufficient to predict future business patterns. On the other hand, business models do not remain constant over time. Companies are likely to modify their accounting, operational and other policies according to business needs. As a result, the historic data recorded in the previous business model becomes unsuitable to be compared with data of the current business model.
2-Ignores external macroeconomic factors
Ratio analysis ignores the external macroeconomic factors like recession and inflation that have an impact on costs and prices. As a result, the changes in price levels between different financial periods are overlooked, making a ratio analysis inaccurate. Similarly, ratio analysis does not take into account the impact of seasonal changes on financial ratios. For instance, the sale of ice cream peaks in the summer months and decreases in the winter season. Hence, an analysis of the total asset turnover ratio in the summer and winter months would not mean an increase in efficiency of the company to turn its asset into sales in summer rather it would be attributed to external factors.
3-Manipulation of data by managers
The authenticity of the ratio analysis is doubted as the managers are known to alter the ratios by the end of the financial year to make the company’s performance look better. Thus, a financial analyst should be aware of such manipulations and conduct audits or investigations accordingly.
4-Inter-firm comparison is not valid
Ratio analysis cannot be relied upon for comparative analysis due to several reasons:
- Organizations use varying accounting methods and procedures. For instance, some firms use FIFO while others use the LIFO method for inventory valuation. Similarly, some firms use the straight-line method for calculating depreciation while others might use the double declining method or units of production method.
- Also, the size and type of firms should be considered while comparing their financial ratios. As we see, a large firm would have the advantage of economies of scale, bargaining power, better technology, etc. so its ratios should not be compared with a smaller firm.
Hence, factors like company size, industry, company regulations, and market structure should be considered in the inter-company comparisons.
5-Does not measure the human element/qualitative aspect of a firm
The input, processing, and output of the ratio analysis procedure are quantitative. There are figures in the financial statements which are computed to obtain percentages. Ratio analysis ignores the why and how behind these figures. For instance, the operating cash flow margin would indicate how efficiently a company produces cash flows or earnings from its sales but it would not include reasons for a good or bad cash flow stream.
6-Do not actually resolve company problems
Ratio analysis is only a method to aid the managers in taking better decisions for the firm if used properly, but it is not a solution in itself. To fix the issues, the managers would have to act based on the insights provided by ratio analysis. So, factors like the manager’s analytical skills, teamwork, resources, etc. would be of significance.
7-No standard definitions of ratios
There are no specific definitions for ratios therefore different companies chose to include different items from the financial statements in calculating ratios creating confusion and making comparative analysis unreliable.
To conclude, ratio analysis can have substantial benefits for the organization only if it is used appropriately considering all of its limitations and adjusting for them. A ratio analysis performed while ignoring the above-mentioned limitations would lead to bad decisions that could seriously harm the organization’s functioning and profitability.