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Objectives and Limitations of Performing a Financial Ratio Analysis
 
 

Objectives and Limitations of Performing a Financial Ratio Analysis

Financial Ratio Analysis Overview:

As a business owner or the manager of a business you might want to develop a reward based system that would incentivize employees to be more efficient and simultaneously give them a quantifiable goal and purpose to achieve. Where would you begin your assessments of performance and how would you take and record these measurements? Hypothetically say that you ran a business and your current liabilities were skyrocketing. How would you know if you are keeping up with them? How would you determine or measure your likelihood of the business to be able to pay its current liabilities? This is where financial analysis and financial ratio analysis become extremely useful to business managers as well as employees.

The term financial analysis refers to collecting the financial data for a business, and then making comparisons amongst different variables in either the same financial statement, across multiple financial statements, or across the business as a whole. Financial ratios allow business managers and investors to establish logical mathematical relationships between different variables (items) that are listed in the financial statements. The main source of financial information for a business will be the four primary financial statements, which are the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows. The footnotes that the management team has included in their financial reports can also serve as a valuable source of qualitative information that helps to understand the thought process of the business owners or management team, as well as the future strategic direction for the business.

There are some businesses that are required by law to file and disclose additional information, such as the information provided in the footnotes. These requirements are generally applied to publicly traded companies. Publicly traded companies are businesses that have made their stock available for purchase to the public. The companies are registered with the United States Securities and Exchange Commission (SEC) and are subject to complying with the guidelines and the financial securities laws of the United States.

When performing financial analysis for a business it is important to examine and take into account other sources of data in addition to the financial statements for the business. The other sources of data that could potentially affect the specific business, the industry or sector specifically, or the economy as a whole will play a substantial role in understand a high-level macro overview of the current condition of a business, the trends that it is currently exhibiting, and the future direction for the business. An example of this type of data would be the United States Consumer Price Index (CPI), which is a measurement of the changes to prices of consumer and household goods. Another example would be the Gross Domestic Product, which is collective financial value of the cumulative finished goods and services within the United States over a yearly timeframe. Additionally other economic metrics such as consumer prices, producer prices, and household spending will all have an effect on the financial state of a company and an impact on the future trends and direction of the company.

Objectives

• You should be able to understand what a ratio means and why they would be useful in comparing data financial data.

• You should be familiar with the four primary areas that are covered by the use of financial ratio analysis.

• You should be familiar with the methods of ratio analysis, and the limitations of using financial ratios.

Explanation of Ratios and Different Types of Ratios:

The word ratio comes from Latin means to reckon or to calculate. Ratio is a mathematical concept that establishes a relationship between one or more variables. Think about if you had 200 dogs and 100 cats. The ratio of dogs to cats is 400/100, which is more commonly written as 4:1 or 4-to-1. The same relationship is true regarding financial ratios. A financial ratio is just simply a comparison of one piece of financial data to another piece of financial data. An example of this that is common used by counts and investors is called the current ratio. Current ratio establishes a relationship between the current assets and the current liabilities of a company. Means if you were to calculate the current ratio you would look through the balance sheet and find where the current assets are listed for a certain time period, then you find where the current liabilities are listed for the same period and simply just divide the number listed in for current assets in the balance sheet by the number that is listed for the current liabilities. The equation for the current ratio would look like this:

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Current Ratio Equation

Current Ratio = Current Assets / Current Liabilities

If a company had a current ratio of 4:1, then it would imply that the company has four times the amount of current assets as it does current liabilities. This means that the company would be able to off its current liabilities four times over buy just using the current assets. There are many different types of financial ratios that are each useful in specific ways (some more so than others); they are classified into groups or categories according to the way that they are derived and how they are specifically used in financial analysis. Additionally there are also different methods for using the ratios that are also separated into categories by their utility in analyzing specific metrics of the financial statements.

Methods of Analyzing Financial Statements:

Horizontal Analysis-

One of the primary methods for analyzing financial statements is known as horizontal analysis. Horizontal analysis is also referred to as trend analysis, which studies the behavior the individual items on a financial statement over multiple accounting periods. His accounting periods can be several quarters inside the same fiscal year or they can be different years altogether. Additionally the analysis may focus on trends of an item in percentages, or as an absolute dollar figure. An example of this would be if a business owner observed that revenue increased from one period to the next by 35% of the total value or by $20 million (absolute dollar figure).

Generally absolute amounts regarding individual items on financial statements of many different uses such as in the reporting of governmental an economic statistics like gross domestic product in household spending. Individuals as well as business owners use this information see how the finances of a company more of an entire sector change over time. An example of this would be a to examine the revenue of a technology company before and after a patent on one of its products expires. When an account nor business owner just a comparative analysis using only absolute amounts then there can be drawbacks with materiality. Since materiality of the financial data refers to its relative importance, it should be noted that the importance of an item can change over time and may no longer affect the decision process of an informed business owner, rendering the item immaterial.

Vertical Analysis/ Common-Size Analysis-

Vertical analysis is also referred to as common size analysis. This type of analysis is done for the users of financial statements that would like to work with data within a single accounting period. Vertical analysis involves preparing common size financial statements which show each item as a percentage of other financial items in the statement. Generally the main advantage of using vertical analysis when analyzing financial statements is that it allows for an easy comparison of business of all sizes. This means that by using a percentage basis it is much easier to compare a multi-billion dollar company with a "small business" that does a few million dollars per year in revenue.

Ratio Analysis-

Financial ratios are a type of quantitative analysis for analyzing financial statements. The many different financial ratios are a means to simplify and organize the numerous numbers involved in financial statements. While these calculations are relatively simple, the information they reveal can lead to great payoffs. A ratio shows the relationship between two values. There are various type of ratios and different ways to categorize the many different ratios. The ratio types we will use include:

Categories of Financial Ratios

· Common Size Ratios

· Liquidity Ratios

· Efficiency Ratios

· Solvency Ratios

Limitations to Financial Ratios:

Financial ratio analysis can be a very powerful tool if the user is attempting to interpret and quantify certain aspects of a business and the financial statements. However there are still limitations to using ratio analysis. Often times many of the limitations are related to the inherent inaccuracies in some accounting data. Inflation also has the ability to drastically distort components of a balance sheet. This is because the values that are used and financial analysis are often times not the true economic value. Inflation can also have an impact on the overall net income of a business due to the fact that I can distort inventory costs and thus will affect the cost of goods sold as well as any depreciation expenses. Much like inflation seasonality also has the ability to distort financial analysis. Seasonality is defined as a characteristic of a time series where the data will be subjected to regular and often-predictable changes that occur every year, these patterns repeat themselves year after year. Seasonality has the ability to affect the comparative analysis of ratios meaning where the ratios of one period are compared to the ratios of another period. A real-world example of this type of seasonality can be found in the toy industry where inventories will generally be very high right before the holiday season and as the holidays come around sales begin to increase drastically and then slowed down again after the holidays are over. Additionally another example can be seen in the purchasing patterns of gasoline. Gasoline has a seasonality effect to it as well because many people and their families take road trips and do substantially more driving during the summer months. Therefore the demand for gasoline goes up in the summer time and then the sales decrease moving into the fall in the winter as people begin to drive less.

The more diverse the operations of a business are the more difficult it can be to perform a comparative analysis. This is because a company that is very diverse and makes money doing a wide range of operations does not have many peers to compare the business to. A good example of this would be General Electric (GE). General Electric can be very difficult to perform a comparative analysis on because General Electric is such a large corporation that they have subsidiaries in the commercial finance industry, the healthcare industry, the oil & gas industry, and the entertainment industry. Finding a peer that is as large or has as diverse of a revenue stream as GE is difficult and therefore it is difficult to accurately compare the financial ratios for GE to any other company. Ratios also have the ability to be too good. For example if a company has a current ratio that is too high meaning they many substantially more current assets than current liabilities that they might be using their cash ineffectively and not growing the company. Having ratios that are too good can also reflect negatively on the owners and management of a business because it implies that they might not be using all of their resources efficiently and might not have a good strategic plan for the company's future.

KEY POINTS REVIEW

  • Financial ratios will generally belong within the framework of four groups. These groups measure the profitability, asset utilization, liquidity, and the burden of debt for a company.
  • The profitability ratios will measure the ability of a business to generate revenues and effectively use its resources in pursuit of profits.
  • The asset utilization ratios will allow you to see how efficiently a company is using its assets and if they are using them wisely or not.
  • The liquidity ratios will measure the burden of debt on a company from two points of view.

1) First it will show the debt principal that is owed relative to the assets that the business owns.

2) Secondly it will show the cash flow that is dedicated to the cost of debt for the business.

  • The horizontal method of analysis will allow the user to make comparisons of the financial balances and accounts between periods.
  • Vertical analysis will allow for analysis of a business or multiple businesses with a single period and is done by preparing a common-size (percentage based) financial statements.

 
 
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