Financial Ratios Essay Example

Brief Description of Financial Ratios

Financial analyses have an integral role in making sense of the corporate performance derived from data from the balance sheet, income, and cash flow statement. By doing so, financial ratios reveal the relationship arising among individual values relative to the company's profitability in the past (Szydlowska, 2018). It offers a base to indicate how the firm may perform in the future. Financial ratios facilitate the evaluation of the company's operating-related performances including efficiency, liquidity, solvency, capital adequacy (Simkovic, 2017). Financial ratios offer a comparative metric against similar businesses over several periods.

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Different Applications of Ratios

Financial analysis enables the regular examination of business performance. Financial ratios help measure and evaluate enterprise performance relative to the previous periods and industry to ensure sustained profitability. Firstly, profitability ratios facilitate comparison of earnings relative to the equity and assets (Szydlowska, 2018). For instance, return-on-equity measures the profits earned from the funds invested, and return-on-assets indicates asset management and capital structure to ensure profitability. Secondly, liquidity ratios, including the current and quick ratio, shows the firm's management of short-term obligations from current assets (Goel, 2014).

Operating ratios derived from sales generated relative to the firm's assets measures the efficiency of utilizing the assets to boost earnings. The turnover ratios on inventory accounts receivable and payable improve the understanding of trends being powerful indicators of the organizational performance (Goel, 2014). The operating ratios pinpoint the strengths and weaknesses associated with the firm's periodic strategies and initiatives. The leverage ratios affirm the long-term financial strength of the business (Szydlowska, 2018).

Financial ratios on solvency and capital adequacy are considered key to the court's consideration of bankruptcy claims. Financial analytic methods are an essential link towards resolving litigations and legal challenges (Simkovic, 2017). For instance, the use of market-oriented analytics is a primary consideration for legal briefs, judicial decisions, and expert opinions. Besides, the discounted cash flow use in valuation influences the bankruptcy courts during solvency analysis (Simkovic, 2017).

Financial ratios complement the discounting cash flow and multiples analysis since no two entities are entirely comparable. Financial ratio analysis simplifies the complex data to numerical representation supporting forecasting of operating profitability. DuPont analysis disaggregates the company's return using the asset turnover, and profit margin to offer insights on the factors influencing profitability (Bauman, 2014).

Strengths of Ratio Analysis

The strength of financial ratios arises from their capability to complement and facilitate adequate capitalization analysis. Mainly, ratios accommodate the historical record of financial performance and quotes to produce clear indicators of expectations by market actors. The ratio analysis offers hindsight-free assessments on insolvency, liquidity, and profitability to various stakeholders (Simkovic, 2017). Additionally, the simplicity of deriving numerical representations from complex financial data saves the users' time and effort. The simplicity in the calculation uses readily available figures from the financial statements for the informative idea about the firm's financial health, profitability, and liquidity (Szydlowska, 2018). Without the ratios, it would be challenging to gather such information and is typically time and effort intensive to review the itemized annual reports.

Weaknesses of Ratio Analysis

Financial ratio analysis exhibits several weaknesses. Firstly, the financial ratio analysis suffers multiple effects where no two firms are entirely comparable. Ratio analysis leaves room for varying opinion about the comparable companies. Secondly, the multiples approach derived through financial ratios fail to capture material information beyond the numbers, thereby insufficient to offer reliable company's assessment (Simkovic, 2017). Moreover, the financial ratio analysis occurring on specific periodic and year-end dates feature filling in gaps through assumed deterioration or improvement of the financial condition. By doing so, financial ratio analysis induces subjective explanations unlike in thorough market-based analysis that uses daily indicators (Szydlowska, 2018).

Simplicity in the calculation of financial ratios ignores the bigger picture. The reduction of complex financial data to single figures and ratios overlooks the unique circumstances (Simkovic, 2017). For instance, a company carrying a high debt-to-asset ratio could be safer than a lowly indebted firm. The receipt of a single impending payment could clear the outstanding debt. Ratios hardly capture such communication, thereby may illustrate the wrong impression.

Ratios analyses utilize data derived from historical financial statements initially prepared from accounting assumptions and principles. The possibility of varying results when using different accounting methods and assumptions makes firms' financials challenging to compare (Goel, 2014). The non-comparable effect in the financial statements translates to ratio analysis, thereby inaccurate. Furthermore, financial ratios rely on the historical data and hardly trace the positive or negative trends in profitability and liquidity to the contributory factors. Consequently, the financial ratios analysis is unreliable to track recent movements in the metrics as generalized explanations cite reduced factors cost, adjusted product mix, or management activities (Bauman, 2014). They rely on generalized trends assumed to develop throughout the period under consideration.

Conclusion

Financial ratios provide simplified assessments of the firm's profitability, liquidity, and solvency derived from the balance sheet and income statement. The hindsight-free evaluation of financial health and solvency offered by financial ratios save on time and effort spent to review the annual reports. The analytic ratios form the basis of experts' opinions, legal briefs, judicial and investment decisions. However, the simplicity in ratio analysis overlooks the bigger picture on underlying drivers of profitability, solvency, and liquidity. The preparation of ratios at year-end assumes a sustained pattern of improvement or decline, thereby unreliable while setting strategies. Instead, the inclusion of market-based analysis will accommodate the daily indicators thus eliminate generalization and subjective explanations.

References

Bauman, M. P. (2014). Forecasting operating profitability with DuPont analysis. Review of Accounting and Finance, 13(2), 191 - 205. doi: 10.1108/RAF-11-2012-0115

Goel, S. (2014). Financial statements analysis: Cases from corporate India. London: Routledge.

Simkovic, M. (2017). The evolution of valuation in bankruptcy. American Bankruptcy Law Journal, 91, 299-310. Retrieved from 10.2139/ssrn.2810622

Szydlowska, K. (2018). Ratio analysis. Financial position of a company. Munchen: GRIN Verlag.