FINANCIAL RATIO ANALYSIS - OBJECTIVES, ADVANTAGES, LIMITATIONS AND USERS

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A financial ratio is an index that shows the relationship between two accounting numbers extracted from the financial statement.

Financial ratios are usually derived from the financial statement and are used to gain more meaningful information about financial information.

Financial ratio analysis is the process of analyzing a company's financial statement using a financial ratio.

Objectives Of Ratio Analysis

1. To provide information that can be used to make future projections and estimates

2. To know the areas of the business that required improvement

3. To provide a more accurate assessment of the company's profitability, solvency, liquidity, and efficiency levels.

4. To serve as a useful measurement for cross-sectional and industry-based analysis

5. To improve the user's understanding of the efficiency with which the business is conducted.

Advantages or uses of Ratio Analysis

1. Helps understand the efficacy of the business: The financial ratio can be used to access the efficacy of financial decisions of a business.

Financial ratios such as profitability ratios and liquidity ratios can be used to access the efficacy of financial decisions (investment, dividend, and financing decisions) made by a firm.

2. Identifies problem areas of the business: Financial ratios can be used to identify problematic areas of the business as well as possible solutions to the problem

3. Useful for comparative analysis: Financial ratios are used to compare year-over-year results as well as industry to industry comparisons.

To put in another way, financial ratios provide information for comparison between organisations and for one year to another.

4. Useful for SWOT analysis: Financial ratio can be used to do strength, weakness, opportunities and threat analysis.

To a great deal, ratio analysis can help management identify the strength, weaknesses, opportunities and threats of the business.

5. Useful for forecasting: Financial ratio provide the necessary tools for forecasting the future prospects of an organisation.

For example, if a company's debt-to-equity ratio is extremely high, we may forecast that the company would have trouble obtaining financing in the future.

6. Measures financial stability: Financial ratios like solvency ratios give a good picture of a company's financial stability.

7. Aids in determining credit worthiness: Financial ratios are used by banks and other credit institutions to determine a company's ability to pay its debts.

Lenders typically examine a company's liquidity and solvency ratios before approving a loan.

Limitations Of Ratio Analysis

1. Dependent on accounting data: The accuracy of ratio analysis is dependent on the accuracy of the financial statements.

This is because financial ratios are generated from financial statements, and any error in the financial statement will result in incorrect ratio figures.

2. Lacks standardized definitions: Most of the terms used in ratio analysis have no conventional meanings

For example, there is no standardized definition of what constitutes liquid assets. 

3. No universal standard for ideal figures: There is no universally accepted standard for what constitutes an ideal financial ratio.

For example, a current ratio of 2:1 is a good ratio, However, it is not universally accepted as the ideal ratio for a current ratio.

4. Difficulty in comparison: Comparing the financial ratios of two companies that use different accounting policies and methods can be difficult.

This is due to the fact that financial ratios are calculated using financial statements, and any changes in accounting practices will necessarily affect financial statements, which will affect financial ratio data.

Furthermore, using financial ratio for inter-company comparison may be unfair given that companies operate under different conditions.

5. Window dressing problem: In a bid to give a good impression of their financial activities, some firms "window-dress" their financial statement, resulting in false financial ratio figures.

6. Does not provide qualitative information: Financial ratio only shows quantitative information.

It does not provide qualitative information, making it unsuitable for qualitative analysis

Users Of Financial Ratios

1. Trade creditors: These are interested in a company ability to pay its debt.

Trade creditors will be interested in a firm's ability to meet its short-term claims.

They may require such ratios as the current ratio, acid test ratio. etc

2. Management: These are general-purpose users of financial ratios.

Because management is responsible for ensuring that the organization runs smoothly,  they will be interested in every aspect of the financial ratio of a company 

Indeed, it is the ultimate responsibility of the management to ensure that a company's resources be used effectively and efficiently.

In addition, management is responsible for ensuring that a company's financial condition is sound.

3. Lenders: These are interested in one thing: repayment.

Lenders may examine a company's long-term solvency as well as its profitability potential to ensure that it will be able to repay its obligations when they become due.

They may also look at the company's capital mix to ensure that it won't go bankrupt anytime soon.

Lenders may look at a financial ratio like liquidity ratios and financial leverage ratios to ensure that the borrower can pay his debts when they are due.

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4. Investors: Prospective investors will not invest in a company that is not doing well financially.

In the same vein, current shareholders of the business must decide whether to buy more shares, sell more shares or keep their holdings.

To achieve all of these, investors require must carefully analyze the financial ratios of the firm.

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